Slowdown Underway But Risks Mounting: Scotiabank’s Forecast Tables

• We continue to forecast a slowdown in Canadian economic activity. A recession seems unlikely given some fundamental strengths, but that hinges to a significant degree on building risks in the global economy.

• The Bank of Canada should be done raising rates but volatile inflation readings, high inflation expectations and very rapid wage growth pose significant upside risk to policy rates in coming months. We continue to expect rate cuts beginning mid-2024.

• Key challenges to the outlook centre on the rapid rise in long-term borrowing costs, which we believe are overdone, and the evolution of the Israel-Hamas War.

While the outlook for the economy and interest rates remains relatively unchanged from our previous forecast, a number of developments cloud the outlook further. First among these is the impact of the significant, and rapid, rise in yields on government debt. A close second is a broadening of the Israel-Hamas War. Finally, Canadian inflation data have been particularly volatile and continue to point to the need for a high degree of vigilance by the Bank of Canada in its quest to return inflation to target. Despite these developments, we continue to believe that the Canadian economy will avoid a recession and that it is likely to land softly as evidence of a slowdown in growth—but not employment—mounts. As a result, we remain hopeful that central banks in Canada and the US are done raising policy rates, but the risks of higher interest rates dominate for the next few policy meetings.

A major development over the last several weeks has been the rapid increase in the yields on US government debt. This rise has spilled over into international capital markets and led to a similarly large increase in yields on Canadian government debt. As of the time of writing, yields on 10-year US Treasuries are flirting with 5%, almost 50bps higher than they were in mid-October. There is a wide-range of possible explanations for this, as well covered by Derek Holt, but there is little question this represents a tightening of financial conditions. Higher financing costs and the potential impact on US bank balance sheets of unrealized losses on Treasury holdings pose a downside risk to the outlook while also potentially acting as a substitute for higher monetary policy rates. Our view is that the surge in longer-term bond yields is out of step with fundamentals and will gradually reverse itself. Nevertheless, the reversal in these yields is expected to be quite gradual with yields above our previous forecast for much of 2024.

The Israel-Hamas War has so far been of limited macroeconomic consequence outside the region but developments there nevertheless have the potential to dramatically impact the global economy if the conflict escalates and involves nearby oil-producing states. This would undoubtedly send global oil prices higher with the only question being how high those prices would rise. Brent prices are up about 6$ since the conflict began, though a number of other factors have also impacted oil price dynamics over that time. A broadening of the conflict could well see oil prices 10 to 20$ higher than current levels. A shock of this magnitude given the weakened state of the global economy would represent a significant headwind to economic activity. For oil-importing countries, the shock would be stagflationary—lower growth and higher inflation. For oil-exporting countries like Canada and the US, the shock would definitely raise inflation but also possibly economic activity given the improvement in terms of trade. That being said, in the current environment, with the weight of elevated inflation and price levels felt on households, the positive impact of higher oil prices on our economy may well be diminished relative to history. With inflation expectations still well above the Bank of Canada’s target, the inflationary impact of higher oil prices could well force the Bank of Canada to raise rates further.

A further challenge is the inflation outlook in Canada. Inflation has been volatile in the last two months. The August reading showed a marked acceleration in inflation which suggested the Bank of Canada may have erred by not raising in September. Thankfully, the September CPI print reversed much of that surprise. Absent additional upside surprises to inflation, the Bank of Canada should be done raising interest rates in this cycle. That being said, underlying measures of inflation have been pretty stable over much of the last year and remain well above the 2% target. We hope to be surprised on the downside on the inflation side, but history over the last year suggests we are more likely to be surprised on the upside. This, in conjunction with high inflation expectations and real wage growth that is wildly outpacing productivity suggests that risks to the policy rate profile in Canada are firmly tilted to the upside for the next few months. As a consequence of these risks and the stronger underlying momentum in inflation, we have reduced the number of rate cuts expected next year. We continue to expect rates to start their descent at the tail-end of the second quarter and for them to end 2024 at 4%. A further 75bps of cuts are expected in 2025, for a year-end rate of 3.25%. A roughly similar path of rates is expected in the US, though given the higher starting point of the Federal Funds Target rate (5.5% vs 5.0% in Canada), the pace of rate cuts should be stronger in the US than in Canada in 2024. This reflects our view that inflation dynamics are more favourable in the US than they are in Canada.