FLCA - Slowdown Or Recession? Canadian Yield Curve Signals Recession
Summary
- The Canadian 10/2s bond yield curve has been deeply inverted since July 2022 as the Bank of Canada stepped up interest rate increases to control soaring inflation.
- As a result, the slope for both the Canadian and US bond yield curves are close to converging to about minus 60 basis points for the 10/2s.
- The worry for investors is that inverted yield curves historically have been harbingers of recessions.
By Sandrine Soubeyran, Global Investment Research, FTSE Russell
The Canadian 10/2s bond yield curve has been deeply inverted since July 2022 as the Bank of Canada stepped up interest rate increases to control soaring inflation, alongside the US Federal Reserve and other major central banks. As a result, the slope for both the Canadian and US bond yield curves are close to converging to about minus 60 basis points for the 10/2s (Chart 1).
The last inversion of the Canadian 10/2s yield curve was in July 2019 when the effects of escalating US-China trade conflicts stifled economic activity and the outlook for the Canadian economy. The subsequent series of easing actions from the Bank of Canada to support the economy through the Covid pandemic shock in 2020 prompted a reversal and a return to a positive slope for the sovereign yield curve.
The worry for investors is that inverted yield curves historically have been harbingers of recessions. With further steep rate rises expected on the horizon, a return to a positive yield curve is unlikely any time soon.
In addition, in its quest to return inflation below its 2% target, there is a risk that the central bank may overtighten. The Bank of Canada has been decisive in raising rates to achieve price stability and its inflation target.
The last round of rate rises from G7 central banks left Canadian rates, at 3.25%, to be among the highest relative to peers, and at their highest levels since the 2008 global financial crisis (Chart 2) .
With a possible time-lag effect of several quarters for monetary policy to work through the economy, the risk of a more severe economic contraction cannot be ruled out as a result.
Inflation easing – is it too good to be true?
Therefore, the extent of the slowdown currently hinges on the hope that inflation may peak soon and start easing, therefore potentially enabling the BoC to reduce the size of its rate increases. There seems to be some early signs of this.
Inflation appears to be easing, after declining for three consecutive months to 6.9% in September (from 8.1% in June), while the Canadian year-on-year change in the M2 money supply has fallen sharply, highlighting the cumulative effects of steep interest rate rises and quantitative tightening (QT).
Indeed, unlike its peers, the Canadian central bank has been an early adopter of quantitative tightening to complement higher rates as part of its policy of tightening financial conditions.
With the initiation of QT, maturing Canadian sovereign bonds have been rolling off the balance sheet, and as a result, the size of the BoC’s balance sheet has been steadily declining since April 2022 (green line).
Finally, if we consider breakeven inflation as a gauge of inflation expectations by financial markets, the decline in long-dated Canadian breakeven inflation since 2022 would suggest that lower inflation and slower growth could be on the way. If so, there may be hope for a shallow downturn after all.
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Slowdown Or Recession? Canadian Yield Curve Signals Recession