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The Bank of Canada and the Federal Reserve both say the timing isn’t yet right for rate cuts. Hafiz Noordin, VP & Director, Active Fixed Income Portfolio Management, TD Asset Management, explains to MoneyTalk’s Greg Bonnell why that could change in coming months and what it could mean for markets.
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The Bank of Canada has held rates steady in its latest decision. BOC governor Tiff Macklem saying, it's too early to even discuss cutting rates just yet. Joining us now for more is Hafiz Noordin VP and Director of active fixed income portfolio management at TD Asset Management. Hafiz, welcome back to the program.
It's great to be back.
It's interesting as we go through this. We weren't expecting a move on rates today. What we were looking for was language as to the path going forward, the word too early appeared a couple of times in the opening remarks, more time. Inflation persisting. As we wrap it all up, obviously, this is a bank that doesn't want to give us-- show us his hand. But where are we headed?
Yeah. I mean, I think what's where the market has gone and where central banks have really not pushed back on is the idea that cuts are coming. It's just when and in what magnitude. And I think from that perspective, what we heard from the Bank of Canada today, similar to the Fed, is that they'd lean more to being patient before starting that cut cycle. And they don't want to be in a situation where they've cut too early and are stoking another re-acceleration in inflation.
That would be the worst outcome, from their perspective. So yeah, I think they're in a situation where they can stay at this high policy rate. They've guided already to not hiking more beyond the current level. So we're staying at this 5% level. And just letting it work its way through. See a little more evidence that inflation is indeed sustainably trending back towards 2%.
They seem to be concerned with underlying inflation. They recognize that housing inflation is a big part of this. But there's other parts there that they're not very comfortable with, and that it's going to be a choppy ride. This seems to indicate to me that they're pushing us out further and further. But the market still feels that by June, we're probably going to be in a position to cut.
Yeah. And I mean, yes, there's housing inflation. But I think one of the concerns that they've been highlighting is wage growth. And when we have these persistently tight labor markets. Unemployment not really moving up much since last year. That does create these concerns that the stickiness in core inflation, that 3% to 4% area we're seeing, could persist, and if wage growth actually also stays in that 4% to 5% area, that will make it tougher for inflation to come back to 2%.
So the flip side, though, is that in June, right now the market is pricing in. About an 80% chance of a cut in June. And that really is based on the idea that inflation can still come down enough that these adjustment cuts can start to come into play, that we're going from 5% to a little bit below 5%. That's still well above their neutral level. That's still restrictive monetary policy. But those adjustments can start to be made.
What do we expect once they do start to move? And if it is in June, and as you said, we're fully in restrictive territory, that we start to see cuts at every meeting after that. And perhaps not huge cuts but they start to realize, OK, now it's time to start bringing it back down?
Right. And I think that's where the market got really ahead of itself early in the year, where it was basically pricing in starting, end of Q1, starting to cut, and then pretty much every meeting after that. I think with the economic data coming in, fairly resilient recently with the growth outlook still pretty strong, with the labor market strong, the idea would be that first cut would start, and probably see a few cuts after that.
But I think there's been an acknowledgment that it may not be a very rapid rate cut cycle. Unless there's some big growth shock. So in this base case scenario, where growth is staying a little bit above 0% and inflation is gradually coming down, we could see some pauses here and there. So that they can make sure that the cuts are not causing inflation to start to rebound. Especially knowing that housing is already started to rebound a little bit.
So I think that's the main thing they have to be careful with.
That wasn't a rate decision day for the Fed but we did hear from Jerome Powell and his testimony to lawmakers. And basically saying, preaching the same mantra. It's like give us some time for this to work its way through. Was there anything interesting there in terms of, I felt like he had told us what he told us before. I feel like the market said yeah, we know?
Yes. Yeah. Pretty consistent with some of the other Fed speakers that have been coming out recently. Be patient, I think in the US, it's particularly more notable that growth right now is trending at more like 3% GDP growth. So that's above potential GDP growth, unlike in Canada, where we're more in the 0 to 1% area. So for the US, we'll see where the jobs numbers comes out. But it's definitely more of a risk that we could see wage growth persisting, perhaps even rebounding.
So I think there, it's a lot more justifiable that the Fed has to be patient. But for even for them at a 5.5% policy rate, this idea of a some adjustment cuts starting in June is reasonable because momentum in inflation certainly has turned since November. And I think that's reasonably reflected in market pricing.
With the US economy as you said behaving this strongly, performing this robustly, despite having rates at this level, is there an argument to be made that perhaps the neutral rate for the United States is a lot higher than we think it is? And perhaps, even where we are right now? If the economy can perform at rates like this, what's the rationale to start cutting?
Yeah. I think that's a great point. And we've seen some of that in market pricing already, where the terminal rate after the any amount of cuts are done is not 1% to 2% anymore, or 2 and 1/2%. It's really north of 3%. So I think there's still some debate happening in the market of where that lands. The Fed themselves will see at the end of March in their dot plot, how they're viewing that. But I think there's definitely the idea that the neutral rates probably 3%, 3.5%.
And that would mean that bond yields in general, it's a lot more difficult to get to the pre-pandemic levels where there were sub 2% and so I think, yeah, it definitely shows that there's been a lot more strength in the growth picture a lot less interest rate sensitivity in the US. We know that they can term out their mortgages to 30 years. Corporates have been terming out their debt.
So the amount of interest rate sensitivity, the vulnerability to higher rates is not as much as it used to be. I think it's harder in Canada though, where we have the five year mortgage rates. And there's a little more sensitivity there. So we should-- we could see this divergence in the two economies persisting.
If we put all that together, what does it mean for the fixed income market this year?
Yeah. So I think the starting point at the beginning of the year was, after really strong rally in bond yields, that were probably perhaps in a bit more of a range, and what we've been starting to see in terms of Canadian bond yields is somewhere a Canadian 10 year bond yield in the 3% to 3.7% range. And so we've seen about a 20 to 25 basis point increase in yields this year, just reflecting stronger growth and pushing rate cuts out a little bit from those aggressive levels where we were seeing.
So I think at this point-- I think we're in a bit of a range because it's hard to break down below 3%, 10 year yields for Canada unless we see a growth shock. And on the flip side, it's hard to get meaningfully closer to say 4%, like what we saw last year when inflation is still behaving OK.
So it's a range trade. And what that means for fixed income investors is that you can still earn a decent level of income with some amount of volatility there. But the income is really your main driver of returns going forward, and still pretty attractive historically.
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The Bank of Canada has held rates steady in its latest decision. BOC governor Tiff Macklem saying, it's too early to even discuss cutting rates just yet. Joining us now for more is Hafiz Noordin VP and Director of active fixed income portfolio management at TD Asset Management. Hafiz, welcome back to the program.
It's great to be back.
It's interesting as we go through this. We weren't expecting a move on rates today. What we were looking for was language as to the path going forward, the word too early appeared a couple of times in the opening remarks, more time. Inflation persisting. As we wrap it all up, obviously, this is a bank that doesn't want to give us-- show us his hand. But where are we headed?
Yeah. I mean, I think what's where the market has gone and where central banks have really not pushed back on is the idea that cuts are coming. It's just when and in what magnitude. And I think from that perspective, what we heard from the Bank of Canada today, similar to the Fed, is that they'd lean more to being patient before starting that cut cycle. And they don't want to be in a situation where they've cut too early and are stoking another re-acceleration in inflation.
That would be the worst outcome, from their perspective. So yeah, I think they're in a situation where they can stay at this high policy rate. They've guided already to not hiking more beyond the current level. So we're staying at this 5% level. And just letting it work its way through. See a little more evidence that inflation is indeed sustainably trending back towards 2%.
They seem to be concerned with underlying inflation. They recognize that housing inflation is a big part of this. But there's other parts there that they're not very comfortable with, and that it's going to be a choppy ride. This seems to indicate to me that they're pushing us out further and further. But the market still feels that by June, we're probably going to be in a position to cut.
Yeah. And I mean, yes, there's housing inflation. But I think one of the concerns that they've been highlighting is wage growth. And when we have these persistently tight labor markets. Unemployment not really moving up much since last year. That does create these concerns that the stickiness in core inflation, that 3% to 4% area we're seeing, could persist, and if wage growth actually also stays in that 4% to 5% area, that will make it tougher for inflation to come back to 2%.
So the flip side, though, is that in June, right now the market is pricing in. About an 80% chance of a cut in June. And that really is based on the idea that inflation can still come down enough that these adjustment cuts can start to come into play, that we're going from 5% to a little bit below 5%. That's still well above their neutral level. That's still restrictive monetary policy. But those adjustments can start to be made.
What do we expect once they do start to move? And if it is in June, and as you said, we're fully in restrictive territory, that we start to see cuts at every meeting after that. And perhaps not huge cuts but they start to realize, OK, now it's time to start bringing it back down?
Right. And I think that's where the market got really ahead of itself early in the year, where it was basically pricing in starting, end of Q1, starting to cut, and then pretty much every meeting after that. I think with the economic data coming in, fairly resilient recently with the growth outlook still pretty strong, with the labor market strong, the idea would be that first cut would start, and probably see a few cuts after that.
But I think there's been an acknowledgment that it may not be a very rapid rate cut cycle. Unless there's some big growth shock. So in this base case scenario, where growth is staying a little bit above 0% and inflation is gradually coming down, we could see some pauses here and there. So that they can make sure that the cuts are not causing inflation to start to rebound. Especially knowing that housing is already started to rebound a little bit.
So I think that's the main thing they have to be careful with.
That wasn't a rate decision day for the Fed but we did hear from Jerome Powell and his testimony to lawmakers. And basically saying, preaching the same mantra. It's like give us some time for this to work its way through. Was there anything interesting there in terms of, I felt like he had told us what he told us before. I feel like the market said yeah, we know?
Yes. Yeah. Pretty consistent with some of the other Fed speakers that have been coming out recently. Be patient, I think in the US, it's particularly more notable that growth right now is trending at more like 3% GDP growth. So that's above potential GDP growth, unlike in Canada, where we're more in the 0 to 1% area. So for the US, we'll see where the jobs numbers comes out. But it's definitely more of a risk that we could see wage growth persisting, perhaps even rebounding.
So I think there, it's a lot more justifiable that the Fed has to be patient. But for even for them at a 5.5% policy rate, this idea of a some adjustment cuts starting in June is reasonable because momentum in inflation certainly has turned since November. And I think that's reasonably reflected in market pricing.
With the US economy as you said behaving this strongly, performing this robustly, despite having rates at this level, is there an argument to be made that perhaps the neutral rate for the United States is a lot higher than we think it is? And perhaps, even where we are right now? If the economy can perform at rates like this, what's the rationale to start cutting?
Yeah. I think that's a great point. And we've seen some of that in market pricing already, where the terminal rate after the any amount of cuts are done is not 1% to 2% anymore, or 2 and 1/2%. It's really north of 3%. So I think there's still some debate happening in the market of where that lands. The Fed themselves will see at the end of March in their dot plot, how they're viewing that. But I think there's definitely the idea that the neutral rates probably 3%, 3.5%.
And that would mean that bond yields in general, it's a lot more difficult to get to the pre-pandemic levels where there were sub 2% and so I think, yeah, it definitely shows that there's been a lot more strength in the growth picture a lot less interest rate sensitivity in the US. We know that they can term out their mortgages to 30 years. Corporates have been terming out their debt.
So the amount of interest rate sensitivity, the vulnerability to higher rates is not as much as it used to be. I think it's harder in Canada though, where we have the five year mortgage rates. And there's a little more sensitivity there. So we should-- we could see this divergence in the two economies persisting.
If we put all that together, what does it mean for the fixed income market this year?
Yeah. So I think the starting point at the beginning of the year was, after really strong rally in bond yields, that were probably perhaps in a bit more of a range, and what we've been starting to see in terms of Canadian bond yields is somewhere a Canadian 10 year bond yield in the 3% to 3.7% range. And so we've seen about a 20 to 25 basis point increase in yields this year, just reflecting stronger growth and pushing rate cuts out a little bit from those aggressive levels where we were seeing.
So I think at this point-- I think we're in a bit of a range because it's hard to break down below 3%, 10 year yields for Canada unless we see a growth shock. And on the flip side, it's hard to get meaningfully closer to say 4%, like what we saw last year when inflation is still behaving OK.
So it's a range trade. And what that means for fixed income investors is that you can still earn a decent level of income with some amount of volatility there. But the income is really your main driver of returns going forward, and still pretty attractive historically.
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