rennie landscape

LONG-TERM GROWTH

Bond investors, who seek nearly risk-free return, must consider inflation expectations. When inflation expectations are high, investors in bonds of the long-term variety (in particular) demand higher yields.

For roughly two decades, inflation was low and stable, and long-term bond yields fell across major economies. Those yields bottomed out in 2020 as economic activity shut down and central banks slashed  interest rates, before reversing course and increasing in 2021 as inflation rose. Long-term yields peaked in most of the world’s largest economies in 2023 as central banks wrestled inflation back towards their respective targets. Since then, long-term yields have fluctuated near their peaks.

The reason for the stickiness of long-term yields—including here in Canada where the Government of Canada 10-year bond yield is up year-to-date though inflation is below target—is because of inflation expectations. The US has implemented tariffs on nearly every country on the planet, which in turn  has started to raise prices for goods and disrupted supply chains. Because of this, as well as concerns about an exploding US government budget deficit, inflation expectations over the longer-term have risen, particularly in the US, and bond yields have followed. This could yield (pun intended) a steeper yield curve for us in Canada going forward, and potentially higher long-term interest rates, even as the Bank of Canada lowers its overnight rate further.

STAYING ON TARGET

After spending the better part of three years being hyper-focused on inflation, we noted in the last edition of the rennie landscape that high inflation was a thing of the past. Our position on this remains unchanged, with headline inflation in Canada having remained within the Bank of Canada’s target range of 1-3% for 20 consecutive months through August. What’s more, inflation has been below the Bank’s targeted 2% since April, aided in large part by the federal government's removal of the consumer carbon tax.

With the Bank of Canada no longer seeing high inflation as the baseline scenario moving forward, it's brought its policy rate to the middle of its theoretical neutral range (within which the rate is deemed to be neither expansionary nor restrictive) of 2.25-3.25%, having lowered it to 2.75% in March. The Bank then maintained this rate through three consecutive rate-review meetings as it sought to understand how the implementation of tariffs would impact both prices and demand in the economy.

The Bank took an unusual step in its July Monetary Policy Report where it ran three different forecast scenarios for Canada: one in which tariff levels remained unchanged; one that assumed tariff escalation; and one that considered tariff deescalation. The good news for Canadians is that in each of the three scenarios inflation is projected to stay within the Bank’s target range through 2027, meaning Bank-induced rate increases are unlikely in the near-term.

With less risk of a spike in inflation being coupled with a weak labour market and economy (discussed earlier) the Bank lowered its policy rate further, to 2.50%, on September 17th. This is unlikely to be the last cut in this rate-loosening cycle as the Bank will likely need to go lower to help stimulate economic growth going forward.

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