Interest rate easing has begun in developed markets, led by the Bank of Canada (BoC), which was the first G7 central bank to cut rates in June 2024. With the Canadian economy slowing and inflation gradually heading back into its target range of 1 to 3%, market expectations for further rate cuts are increasing. On the other hand, the U.S. economy continues to be quite robust. As such, rate cuts are yet to be a reality south of the border, leading to divergence in interest rates between the two markets. This has economic implications that investors need to be aware of.

Economic Indicators Influencing Policy Decisions

At the start of 2024, many market analysts expected the U.S. Federal Reserve to lower its key rate up to six times over the year, despite the Fed's own forecast of three cuts. However, as new economic data emerged over the past six months, these expectations have been significantly reduced. The bond market is now expecting modest rate cuts in 2024.

Interest rates have impacted economies in different ways since central banks began raising them. While developed economies embarked on a hiking cycle together due to shared factors such as supply chain disruptions and increased demand for goods and services fueled by government stimulus packages, the easing cycle in each country will be different due to domestic factors.

Several data points are crucial to consider in determining the extent of Canada's deviation from U.S. monetary policy: inflation, economic growth and productivity, labour markets and rate sensitivity.

• Inflation: Since its peak in June 2022, Canada's Headline Inflation rate has fallen below 3%¹ and has stayed within the BoC's target range since the start of 2024. While U.S. inflation has been slowing, it has only just come under 3%², and some measures like prices for Core Services are still elevated. The Fed needs to see further decrease in inflation to begin cutting.  
• Economic Growth and Productivity: The Canadian economy has grown below its trend rate for nearly two years and Real Gross Domestic Product (GDP) per capita has not grown since 2020, significantly underperforming the U.S. and other G7 peers. Furthermore, Canadian GDP per capita relative to the U.S. has also declined since the 1970s. Meanwhile, the U.S. economy has sustained growth above its trend rate despite higher interest rates.
  
• Labour Markets: While wage growth continues to be strong for both Canadian and U.S. economies, Canada's current unemployment rate of 6.4%³ is the highest since early 2022. The unemployment rate in the U.S. was 4.1% for June 2024⁴, indicating a relatively tight labour market by historical standards. The Federal Reserve operates under a dual mandate of maximum employment and price stability, so it will be sensitive to labour market changes, but current levels do not necessitate policy adjustments.
• Rate sensitivity: Canadian households are more sensitive to interest rates than their U.S. counterparts. This is due to the fact that Canadian households have debt levels which are 80% higher than U.S. ones – and they are spending 15% of after-tax income on debt servicing,  which is 1.5 times higher than in the U.S⁵. In addition, shorter mortgage refinancing terms in Canada increase the rate of interest paid on debt faster than in the U.S. This makes Canadian household debt more vulnerable to interest rate fluctuations. Over half of Canadian mortgage holders, which are 36% of the population, have yet to face higher interest rates due to mortgage resets, with projections indicating that mortgage payments for renewing mortgages could rise by 22% on average this year and up to 32% by 2026⁶. This anticipated increase in mortgage costs has led Canadians to save more, thereby reducing their discretionary spending compared to U.S. households.⁷

Considerations on Deviation

By how much can Canada deviate in its interest rate policy? Two key factors to consider are the impact of divergence on the Canadian dollar and the size of the divergence.

• Impact on Canadian dollar:  Movements in the Canadian dollar are expected to have a modest to small impact on inflation. The majority of goods and services Canadians consume are produced domestically, and over half these expenditures are on services, which are less impacted by exchange rates.⁸ Further, BoC research shows that a 10% depreciation of the Canadian dollar results in a 0.3% increase to core inflation, which is manageable.⁹ This small temporary increase in core inflation due to currency effects is something the BoC can consider when determining policy moves.
• Size of Divergence: Divergence between U.S. and Canadian rates is not a new occurrence. Reasons have varied but we've been here before. Historically, when policy rates were in restrictive territory (i.e., when the Fed Funds Rate was higher than 3%) the BoC lagged the Fed by 75 basis points or more, roughly 50% of the time¹⁰. TDAM believes that on an ongoing basis, a divergence of 150 basis points is manageable. However, this is not our base case scenario as conditions can change rapidly, and only incoming data can truly reveal the path forward.

It is important that Canada isn't considered in isolation, as the U.S. policy rate is diverging from many of its trading partners' policies, including those in the Eurozone.

While we at TDAM believe a divergence of 150 bps between Canada and the U.S. is manageable, this is not our base case. The extent of the deviation in this cycle will depend heavily on evolving economic data. Both the BoC and market analysts are data-dependent, monitoring the key economic indicators outlined above to guide policy decisions.

_{¹ Source: https://www.statcan.gc.ca/en/start (as of July 16,2024)}

_{² Source: Bloomberg Finance L.P. (as of June 2024)}

_{³ Source: Bloomberg Finance L.P. (as of June 2024)}

_{⁴ Source: Bloomberg Finance L.P. (as of June 2024)}

_{⁵ Source: Federal Reserve of St. Louis: https://fred.stlouisfed.org/ (as of October 31, 2023)}

_{⁶ Source: Bank of Canada: https://www.bankofcanada.ca/2024/05/financial-stability-report-2024/ (published May 09, 2024)}

_{⁷ Source: Bank of Canada: https://www.bankofcanada.ca/2024/05/financial-stability-report-2024/ (published May 09, 2024)}

_{⁸ Source: Bank of Canada: https://www.bankofcanada.ca/wp-content/uploads/2015/10/dp2015-91.pdf}

_{⁹ Source: Bank of Canada: https://www.bankofcanada.ca/wp-content/uploads/2015/10/dp2015-91.pdf (published Sep 2015)}

_{¹⁰ Source TD Economics: https://economics.td.com/ca-history-of-policy-rate-divergence (Published May 29, 2024)}

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