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Weekly Commentary

Sometimes Starting Points Matter

January 24, 2025
Royce Mendes
Managing Director and Head of Macro Strategy

Markets are expecting both the Bank of Canada and the Federal Reserve to cut rates by about the same magnitude this year, even though the economic situations in each country are materially different. Canada heads into the year with an elevated unemployment rate and slack across the economy, although that’s not much different than most other advanced economies. In contrast, America’s economy has been in a league of its own over the past year, showing remarkable resilience in the face of high interest rates.

 

The reason the market is pricing in a similar number of rate cuts in each jurisdiction stems from the differing starting points for each central bank. The Bank of Canada has cut interest rates by 175 basis points, taking the domestic policy rate down to 3.25%. Meanwhile, the Fed has lowered its policy rate just 100 basis points from its peak, with the target for fed funds now 4.375%. Despite the lower starting point and more aggressive cutting cycle in Canada, the question market participants should be asking themselves is whether the difference in starting points is enough to account for the divergent paths of the two economies.

 

We don’t believe that gap adequately reflects the reality facing the two nations. Domestic challenges in the form of sharply slower population growth and the increasing impact of mortgage renewals this year will provide a meaningful drag on the Canadian economy. The US outlook is much brighter, bolstered by the tech boom, lower household debt ratios and longer-term mortgages.

 

While there is a lot of uncertainty surrounding the prospects of a trade war, it’s fairly obvious that any disruption would impact the medium-sized open economy of Canada more negatively than it would the larger and more insular US.

 

While we disagree that the starting points for rates have much bearing on the path forward, we do believe that the starting points for each economy will matter for how central banks respond to any trade disruptions. The Bank of Canada, dealing with an already weakened domestic economy, will need to focus on supporting growth instead of worrying about the risk that a one-time price increase from exchange rate depreciation and retaliatory tariffs somehow becomes a more sustainable source of inflation. In the US, Fed policymakers have more flexibility to wait and see how tariffs play out, a luxury most other central banks don’t have.

 

As a result, while the Fed can likely hold its policy rate steady until mid-year, the Bank of Canada will need to cut rates next week and at least once more in the first half of 2025. This will keep the Canadian dollar weak against its US counterpart. The risk to this forecast is that tariffs come earlier or in greater magnitude than we now expect. Make no mistake, if that’s the case, the Bank of Canada will be cutting rates more not less, which could push the loonie to levels not seen in almost a quarter century.

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