Economic Stability Comparing Canada and the USA

Although interest rates have increased roughly equally in the US and Canada, there has been a noticeable difference in the impact on the economy on this side of the border. Take a look at what transpired the previous year, when Canada's GDP growth was limited to 1.1%, significantly less than the 2.5% rise reported domestically. The entire reason for the performance discrepancy was domestic demand, especially for interest-rate-sensitive GDP components like housing, consumer expenditure, and business investment. Furthermore, it seems unlikely that Canada will catch up to the United States in 2024 given that rates will probably remain high for some time. Positively, Canadian farmers and food and beverage producers should see a respectable increase in exports as a result of the ongoing economic growth in the United States.

Greater burden of repaying debt in Canada

The fact that high interest rates are more painful on this side of the border shouldn't surprise anyone. In addition to having more debt than Americans, Canadians also tend to renew it more frequently. For example, mortgage terms in Canada typically last no more than five years, whereas in the US, 30-year mortgages are not unheard of. All of that indicates that Canada has a higher household debt burden.

It is noteworthy that in Canada, the debt service ratio exceeds 15% of disposable income, but in the United States, it is less than 10% (Figure 1). Back in 2005, the burden of debt service was comparable for both nations. However, since then, there has been a noticeable difference as the Financial Crisis of 2007–2008 (and the subsequent collapse of the American housing market) forced significant household deleveraging in America, while Canadians took the opposite approach and continued to take on debt in tandem with a rising housing market.

When interest rates surged to multi-decade highs in the post-pandemic era, it became evident that they were more sensitive to interest rates than Americans were. The increase in rates led to a dramatic contrast with the observed decline in the savings rate within the United States; in Canada, the household savings rate quadrupled from approximately 3% before the pandemic to 6.2% by the end of 2023. Spending was obviously impacted by that.

Over the past four years, the growth of service consumption has been roughly equal in both countries. However, the growth of goods expenditures in Canada has been five times slower than in the U.S. during this time. This slowdown has been caused by the high cost of highly rate-sensitive durable goods, or long-lasting goods like cars, electronics, or appliances (Figure 2). This is especially noteworthy in light of the fact that throughout this time, Canada's population growth exceeded that of the United States. The fact that Canada's per capita food expenditure fell in 2023 and food and beverage producers had only modest sales increase (mostly due to their success in a few export markets) should likewise not come as a surprise.

Below-potential growth will reduce inflation's momentum

Anticipating that the debt service ratio will remain high due to impending mortgage renewals, Canadian consumption is likely to continue underperforming in comparison to the United States (though we anticipate spending growth to decrease stateside as well due to a low savings rate). This year's challenges for consumers are also anticipated to include rising housing expenses and a contracting labor market. An additional obstacle is the anticipated slowdown in population expansion. Therefore, it shouldn't come as a surprise if consumer spending—which accounts for 60% of the economy—and real GDP growth this year continue to stagnate.

The inflation issue should be resolved after two years of below-potential growth, albeit more slowly than some had anticipated. Core inflation is declining, albeit very slowly, as it does not include volatile items and is therefore a better indicator of underlying price pressures (Figure 3). Nonetheless, considering that wages—a significant expense that certain companies have been passing along to customers—remain high relative to the pre-pandemic growth rate, the persistence of core inflation should not come as a surprise. However, later in the year, the labor market's anticipated loosening and the ensuing increase in the unemployment rate should deflate wages and reassure the central bank that the core inflation trend is sustainable. That will significantly affect interest rates.

Ramifications for the dollar and interest rates

The yields on Government of Canada bonds are gradually rising again across the yield curve, following multi-month lows at the end of 2023 (Figure 4). Naturally, that was made possible by a number of economic forecasts that indicated inflation would continue to rise. Because of this tenacity, the Bank of Canada (BoC) was forced to go against market expectations and take a more hawkish position, delaying expectations of interest rate reductions.

when previously indicated, when the labor market slows down in tandem with a faltering economy, wage growth and inflation will begin to decline later this year. However, the entire effect of this process will take some time to manifest. Therefore, even though bond yields might increase slightly in the immediate future, the longer-term downward trend will continue when inflation starts to decline more significantly later in the year.

Since near term yields are dependent on the BoC's overnight rate, they probably won't fluctuate much for the time being. At its meeting in March, the central bank restated its position that, given the continuation of inflation, interest rate reductions were not something it was considering. To put it another way, the already-inverted yield curve may become much more so in the near future, meaning that short-term rates will continue to rise while long-term rates will decrease. However, watch for the yield curve to become less inverted on the way back to its normal positive slope once the central bank begins reducing rates in the second half of 2024 after it is convinced that the downward trend in inflation is sustainable. At this point, we currently project three rate cuts totaling 25 basis points by the end of the year.