If, When, and How

They say that everything works until one day it doesn’t. Today I believe was that day. This morning we had Canadian retail sales announced, and it was all around ugly. Not just your regular run of the mill ugly – this report started in the ugly tree, fell out of the ugly tree, hit every ugly branch on the way down, and then landed on the ugly ground.

Up until this report, there was always a debate about the numbers being released, from employment numbers, to GDP, to retail sales, etc.. The argument was what we should be looking at. For example, the employment reports were showing we were creating jobs in Canada. Not a lot, but let’s say 10,000 jobs. The issue is that when you are adding 75,000 to the population every month, is 10,000 jobs enough? Some say yes, and some say no, but it was a debate. When GDP was growing 2% a year, but the population was growing 3% a year, then the PER CAPITA GDP was still lower, but the headline number was higher. Again, it was cause for debate. Some said it didn’t matter, and some said it was the end of the world.

However, today we witnessed a number that leaves no room for debate – the sales report this morning showed another drop. Q1 retail sales fell .40%, and with the May reading in, and the June numbers, we are looking at a drop of another .20% in Q2 – and that was even after the April numbers blew the doors off – the only positive month in 2024 for retail sales. So, it is bad enough that retail sales are dropping ( ugly ), but add that to the fact that we are adding around 75,000 people a month from immigration, ( really ugly ), and then add on the fact that inflation should be bumping up those numbers year over year by at least 2.7% ( super ugly ). 8 of 9 subsectors that they track saw lower receipts in May. 8 of 9, or basically 88% of the categories saw a pullback in spending. Like I said, there was not a damn thing to get even remotely positive about.

As most of us know by now, bad news for the economy is good news for people who want lower interest rates. Todays report, in conjunction with some weaker readings elsewhere have basically locked in a July rate cut next week from Tiff and Co. Odds sit around 85% ish that we see a 25 bp drop in rates.

Todays retail sales report, taken in conjunction with GDP, unemployment, and a plethora of other economic reports proves we have also moved down the path a little bit in the current cycle. We have gone from the ” If the BOC will cut “, and ” when will the BOC cut “, and we are now moving into the stage of ” How much will the BOC cut”. Yep. That is where we now live. Odds makers are now not worried about the details of July vs. September, or 25 bps vs. 50 bps, but rather where is the floor. Just how low will the BOC cut rates. That is all that matters now.

The reason this is important is that markets, bond or otherwise, are forward pricing instruments. They don’t much care about todays conundrums, but rather the issues of next month, next year, and the next decade. Bond markets are very forward looking. Being so forward looking, bond markets aren’t going to get all wrapped up in the minutia of July vs. September, but rather start to look at when the floor might be in, and where that floor will be. At this point on the cycle it matters not if we go down 25 bps every meeting, or 50 bps every other meeting, it only matters where we stop. Knowing where the floor of rates is going to be is a lot more important than the speed at which we do or don’t get there. Directionality is a given ( lower ), speed is variable, but the end destination is what is important.

The issue with this stage of the cycle is that it can cause people to get ahead of themselves. I always liked to say that ” forever and never in this business is only 2 years long”. Finance has a way of creating short memories for many participants. While lower rates from the BOC are a given, I think it would be foolish to suggest we go back to the days of 2021 with a 2.45% Prime Rate. I also think that a lower BOC overnight rate will mean different things in this cycle than it has in past cycles. We must remember that the BOC is going to lower rates because, well basically ,the Canadian economy is in the process of shitting the bed. The last 2 times we witnessed extremely low rates were from outside influences. COVID 19 ( 2020 ) and the subprime housing collapse ( 2007/2008 ) were factors that made central banks drop rates to avoid a shock to the system. This time interest rates ARE THE shock to the system. When the central bankers of the world dropped interest rates in 2007/2008 and 2020, they were doing so to try and prop up the economy, and ensure the shocks of outside events did not freeze markets up. This time around, interest rates were raised to try and slow the economy down – these are different scenarios.

Even though the BOC will be lowering rates in the coming months, there are 4 very important factors that you need to keep in mind:

1. The last 2 times were different, this time around will be a repeat of normal interest lowering cycles. If you want to see what happens when rates come down, look at recessions prior to 2007 to see what the economy looks like. History goes back a lot farther than 2007, so make sure you don’t get caught up in 2007 and beyond data only. You need data going back 30, 40, 50 and 75 years to truly see what happens.
2. Rates will not drop as far as you think they will. Yes, the BOC will start dropping rates to spur the economy, however we are not going back to 2021 rates – at least not yet. Keep in mind that the lower the rate drops from here, it is only because the data is an absolute shit show. The reason the BOC will drop rates is because people lose jobs, it is because people lose houses, it is because people claim bankruptcy, it is because people don’t have money. Rates aren’t simply dropped because, they are dropped in reaction to bad shit happening. The only time you dial 911 is when there is a problem, and the only time interest rates get dropped is for the same reason. Lower interest rates are the first responders of the financial world.
3. While the BOC, Uncle Tiff ,and the US Fed wield a lot of power and influence, they specifically wield this influence over the overnight rate ( variable ) and over the very short end of the bond yield curve ( 1, 2 and depending on who you ask 3 year rates ). Most of the power on the 4 year and above is set by our good friend Mr. Market, and while the central bankers have some influence, they certainly do not control the market like they do the overnight and short end of the curve. This means that you could very possibly see a world where the BOC drops the overnight rate by 25 bps, and the 5 year fixed goes UP!!! A lot of the Canadian bond market is controlled by foreign investors, and as such there is a currency factor at play. There is a lot to unpack there, but just be aware that a 25 bp drop on July 24 does not translate bp for bp to the fixed market.
4. Cheaper rates does not equal rocket ship emojis for housing. Housing will not react the way it did in the last 2 easing cycles. First and foremost a lot of the luster has worn off of Canadian housing, and it is no longer a “sure thing” and it is no longer an investment. Rates will have to come down around 200 to 250 bps to make housing an investment again. Secondly, unemployed people cannot and do not buy houses. With unemployment ticking up ( and no government CERB checks this time around ) you are gonna be hard pressed to buy a house if you don’t have a decent job.

We must remember that 5 year bond are priced to reflect where the market thinks things will be in 5 years. Remember back in 2020 and 2021 when the 5 year fixed was a stupid rate like 1.69%?? Well, when these come due later this year, and into next year, there is a good chance that the Canadian economy is in a whopper of a recession, so the bond market was pretty accurate 5 years ago.

While I can’t wait for next weeks Tik Tok videos after the BOC meeting, I also hope that we start to get a better understanding as an industry that BOC cuts are not something to dance about, they are not something to jump for joy about, and they certainly are not good news. We need to start helping our clients, but if we don’t even understand the basics of finance, we become the blind leading the blind. We need to really understand the economics of our industry to help guide our clients towards their goals.