Expect More Rate Cuts If Inflation Eases
The Bank of Canada (BOC) cut the key interest rate by 25 basis points for the first time in four years to 4.75%. Now, investors are eager to know the trajectory of the interest rate policy. Will the BOC continue to reduce the rate? How many times and how far will they go? Let's dive in to see the details.
BOC More Confident Inflation Moving Towards Target
Inflationary pressures have eased enough to finally convince the BOC that its monetary policy no longer needs to be as restrictive. In fact, should inflation continue to slow, "it is reasonable to expect further cuts," said BOC Governor Tiff Macklem at a press conference following the policy announcement. As a result, the central bank cut the main policy rate to 4.75% from 5%.
But let's be clear: just because monetary policy doesn't need to be "as restrictive" doesn't mean it is not restrictive. In fact, the BOC continues to normalize its balance sheet, which is also referred to as quantitative tightening.
A gradual path, one meeting at a time
How fast and how far will monetary policy easing go? Comments from the BOC governor point to a gradual pace, reflecting the central bank's expectation of a gradual return of inflation to the 2% target.
In other words, if you expected rates to come down as quickly as they rose, this isn't what the central bank is signaling. The reason is that the fast pace of rate hikes mirrored the rapid acceleration of inflation. Canada's inflation rate soared to 8.1% in June 2022 from 0.1% in July 2020, followed by a rapid improvement through June 2023. Since then, progress has been slower, and the BOC indicates it's expecting the last mile to be gradual. The timing and scope of rate cuts will be data dependent.
What is the BOC watching?
While the BOC pays attention to a wide range of indicators, it will particularly focus on four categories:
· The balance of demand and supply in the economy
· Inflation expectations
· Wage growth
· Corporate pricing behavior.
Should the economy evolve as the central bank expects, more cuts are likely. The BOC will provide its updated economic projections in its Monetary Policy Report (MPR) in July. The April MPR projected Canada's annualized GDP growth at 1.5 percent in the second quarter. The first quarter came in at 1.7 percent, below the BOC's 2.8% projection. A soft landing remains the preferred scenario.
How much can the BOC diverge from the Fed?
In response to journalists' questions about the divergence between the BOC and the Fed's monetary policies, the central bank reminded that drivers of inflation were initially international, leading to coordinated tightening by several central banks, including the Federal Reserve and the BOC. As inflation is approaching its target, domestic economic drivers are becoming more important, which leaves the door open for the possibility of diverging policy decisions between the BOC and the Fed. The BOC governor indicated that while there are limits to how far the two central banks can diverge, we're not close to these limits
What are the opportunities for investors?
Lower interest rates unlock opportunities such as high dividend assets that could experience an increase in valuations adding to the attractiveness of their cash flow generation.
Under a soft landing scenario, as expected by the BOC and markets, market liquidity, and risk appetite both tend to increase, leading investors to pursue higher potential returns. In such situations, the overall valuation level of the stock market often rises. High dividend stocks, with their inherent defensiveness and stable cash flow generation, become even more attractive to investors as the risk-free interest rate decreases, resulting in a reduction in the discount rate and an increase in the present value of the stocks. Their valuation may increase even further, becoming an object of pursuit for capital inflows.
Under a soft landing scenario, as expected by the BOC and markets, market liquidity, and risk appetite both tend to increase, leading investors to pursue higher potential returns. In such situations, the overall valuation level of the stock market often rises. High dividend stocks, with their inherent defensiveness and stable cash flow generation, become even more attractive to investors as the risk-free interest rate decreases, resulting in a reduction in the discount rate and an increase in the present value of the stocks. Their valuation may increase even further, becoming an object of pursuit for capital inflows.
Disclaimer: Moomoo Technologies Inc. is providing this content for information and educational use only.
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