September 2023 BoC: Taking the Off Ramp from Rate Hikes

The Bank of Canada (BoC) followed the path of least resistance by holding the overnight rate unchanged at 5.00% in September without closing the door on rate hikes going forward. Most of the uncertainty around the decision had already dissipated after the surprise contraction on Q2 GDP that was released on September 1st. This dampened most (if not all) of the speculation around a September rate hike, and it would have been an uphill battle for the Bank to defend another rate hike given more concrete evidence that higher rates are already working to slow demand. However, the Bank did not take hikes off the table going forward as it will continue to assess whether incoming data are consistent with achieving the 2% inflation target.

The September policy statement mostly kept the hawkish messaging intact, with the Bank expressing concern over the persistence of underlying price pressures. The Bank noted upside risks to inflation from higher oil prices in the near-term and cited the symmetry between y/y CPI and 3m rates of core inflation as evidence of the lack of downward momentum. The statement also noted that wages have remained elevated in the 4-5% range despite a broader easing of labour market conditions, which speaks to the risk that inflation expectations become entrenched near these levels.

While the Bank of Canada was not ready to declare mission accomplished on rate hikes, it did acknowledge that we have entered "a period of weaker growth" on the domestic front. The Bank attributed some Q2 slowdown to wildfires but still conveyed a more dovish tone on the growth outlook, with an explicit mention of tighter credit conditions for the household sector. The most dovish element of the statement was the first line of the final paragraph where the Bank noted "recent evidence that excess demand in the economy is easing" and cited policy lags as a factor in its decision to keep rates unchanged.

The Bank is not taking any options off the table here, and we would stress that the dovish elements of the final paragraph were followed immediately by the Bank's concern over inflation persistence and an explicit pledge to hike further if needed. The Bank will also continue to monitor "the evolution of excess demand, inflation expectations, wage growth and corporate pricing behaviour" going forward. However, we would note that Bank of Canada communications can have a short shelf-life, so there is no guarantee that the more hawkish messaging in today's policy statement will persist into October, and Governor Macklem will indeed have an opportunity to refine his message in some of his speaking appearances in the following days.

Market Implications

Rates: BoC balanced lagged effects and slowing growth in making the hold call which we see as the right decision. As we look forward to the next rate decision in October, there will be two CPI prints before then; the print that we will see in October when combined with the GDP numbers and Q3 BoC Surveys will really set the stage for the October meeting. We may not see CPI tick much lower into October with base-effects working against us. Softer activity data and more progress on inflation expectations is where our bias lies, but it also where the risk lies. Taking this altogether, with all-in yields near the local wides, a string of weak data across the board in North America could really set up for quite the bond rally relative to how high we can see yields go into October.

FX: It is hard to disentangle the impact of the BoC decision against stronger US data released at the same time. But the markets seemed a bit more interested in the ISM report, where ISM Services came in near 4 standard deviations above consensus, helping to lift rates and provide some additional juice to the USD. The BoC, for its part, wasn’t exactly dovish, likely surprising markets on the hawkish side. Noting concern about sticky inflation, it's keeping another rate hike on the table. The BoC also pointed to strong wage growth and downplayed the recent growth weakness. Market pricing responded by adding some tightening back into Q4. For USDCAD, we believe that risk/reward still favours fading rallies, reflecting a nice CAD discount across our short-term tools (High-Frequency Fair Value estimate remains sub-1.33). We also expect to see GBPCAD move lower reflecting the growth theme related to NA and Europe.