The Investment Landscape Following the Upcoming BOC Interest Rate Decision

The market will closely watch this week to see if the Bank of Canada (BOC) will cut its interest rate. Analysts believe that, given the slowing economy and inflation, the BOC is likely to initiate rate cuts starting next week, in contrast to the likelihood of the US Fed delaying its cut. With monetary policy easing underway, what investment opportunities will emerge in Canada?

Canada's economy is losing momentum as high interest rates take their toll, with the national economy growing at an annualized rate of 2.5% in the first quarter, exhibiting a consistent monthly slowdown. Canada's real GDP per capita has deviated from its long-term trend. Since 1981, real GDP per capita has experienced an average annual growth rate of 1.1%. The shock of the COVID-19 pandemic, combined with recent quarters' declines in per capita output, has left real GDP per capita 7% below its long-term trend.
In the face of a declining economy, the Bank of Canada (BOC) is expected to lower interest rates to stimulate economic activity. Markets currently anticipate a 75% likelihood of the BOC initiating rate cuts in June, with a projected reduction of 25 basis points.

The US economy experienced a sharp slowdown in the Q1 of this year, recording a 1.6% annual growth rate, the slowest pace since the second quarter of 2022. However, consumer spending remained robust, growing at a 2.5% in Q1, underscoring its role as a key driver of economic growth.

More importantly, inflation remains a significant concern. The personal consumption expenditures (PCE) price index excluding food and energy, one of the most important indicators for the Fed to reference when assessing inflation, surged at a 3.7% rate in Q1, above the expectations and well above its 2% target.

With the persistence of inflation and a strong economy, CME Group 30-Day Fed Fund futures prices, which tend to signal the market's expectations regarding potential changes to US interest rates based on Fed monetary policy, indicate that half of traders estimate the FOMC will lower its fed funds rate by 25 basis points to 5.00-5.25 in September. However, considering the factor of the US presidential election, some analysts expect the rate cut to occur in November or later.

The divergence between two central banks—where the BOC adopts a more aggressive approach to accommodate the economy while the Fed upholds a dovish stance to tackle high inflation. It leads markets believe that there are roughly 90 basis points difference between the two central banks.

While the Fed maintains its interest rate and the BOC, in contrast, lowers its rate, this would typically make holding USD-denominated assets more attractive compared to CAD-denominated assets. This could lead to a decrease in demand for the Canadian dollar and potentially cause it to depreciate relative to the US dollar.

Export companies: Canadian exporters benefit from a weaker Canadian dollar when creating their goods, as it lowers manufacturing costs. U.S. buyers need to spend less of their own currency to purchase Canadian goods. This increased affordability can lead to higher demand for Canadian exports, boosting sales and potentially increasing profits for exporters.

a. Natural resources: Companies exporting commodities such as oil, natural gas, minerals, and lumber often benefit from a weaker currency, as their products become more competitively priced on the global market.

b.Agriculture: Exporters of agricultural products such as wheat, canola, and seafood can gain a competitive edge internationally when the Canadian dollar depreciates, as their products become more affordable for foreign buyers.

Import companies: When the Canadian dollar depreciates, it takes more Canadian dollars to purchase the same amount of foreign currency, increasing the cost of importing goods from other countries. Consequently, importers may encounter higher costs, which could lead to increased prices for imported goods and potentially reduced consumer purchasing power, such as retailers and food and beverager.

a. Retailers: Importers of consumer goods such as clothing, electronics, and household items may face higher costs when purchasing goods from U.S. suppliers due to the increased exchange rate.

b. Food and beverage industry: Importers of food products from the U.S. may face higher prices for imported ingredients or finished goods, potentially resulting in increased prices for consumers and make it less

competitable for consumers.

Furthermore, a cut in the interest rate environment will also benefit the banks. During periods of high interest rates, customers often find it difficult to make mortgage and credit card payments. This leads to an increase in bad debts and delinquency rates, putting pressure on the profitability of banks. However, a reduction in the interest rate environment will improve debt repayment and ultimately benefit the banks.

This year, the S&P/TSX Banks index has risen by 0.9%, compared with a 6.7% gain for Canada's benchmark S&P/TSX Composite. Over the past 5 years, the banks index has gained 19%, which is about half of the 37% surge seen in the broader Canadian stock gauge. The market perceives a potential for the banking sector to make a comeback.