Dollar and Japanese Yen
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Stocks at Risk, Dollar and Yen May Rise as Canada Flags U.S. Recession Risk

By:Ilya Spivak

Wall Street may suffer if a dovish Bank of Canada fuels fear of a deepening slowdown in the United States and a global recession fears

  • The Bank of Canada is seen as holding rates as the economy slows and inflation falls.
  • Unexpectedly weak growth speaks to unraveling of demand in the U.S.
  • A dovish policy guidance may fuel fears of recession fears and drive Wall Street lower.

Canada’s economy is in trouble.

Gross domestic product (GDP) unexpectedly fell at a blistering annualized rate of 1.1% in the third quarter, marking the worst performance since the three months ending in June 2021. Leading purchasing managers’ index (PMI) data paints an even darker picture thereafter. It shows economic activity shrinking at the fastest pace since May 2020.

Meanwhile, inflation has resumed moving lower after an unwelcome bounce over the summer. Consumer prices grew 3.1% year-on-year in October, marking a four-month low. The five-year breakeven rate—a measure of medium term inflation expectations priced into the bond market—has stabilized at 2%.

The housing market offers a still more dramatic disinflationary signal. “Shelter” is the largest component of the benchmark consumer price index (CPI). So, it isn’t surprising to see housing prices anticipating changes in overall inflation, with a lead of close to 10 months. They’ve been falling since April, setting the stage for the CPI to follow.

Canada to end rate hikes as economy suffers, inflation falls

The markets reckon that all this will keep the Bank of Canada (BOC) on the sidelines when Gov. Tiff Macklem and company deliver the results of December’s policy meeting this week. The priced-in probability of a 25-basis-point (bps) rate hike is a mere 6.5%.

Canada Market-implied Policy Rates
Source: Bloomberg

In fact, no further tightening is seen on the menu. As with most of the world’s central banks, November marked a sharply dovish shift in the expected policy path, led by the Federal Reserve. The first 25bps BOC rate cut is due to appear no later than April. Three of them are fully baked into the outlook for 2024, with a 46% probability of a fourth.

A dovish adjustment may be in store as the central bank’s rhetoric nods at deteriorating economic conditions and hints more overtly that the tightening cycle has concluded. That would echo recent guidance from central banks in the Eurozone, the U.K., the U.S. and just this week in Australia.

Canada’s woes are a warning about U.S. growth

On the surface, that bodes ill for the Canadian dollar. Considered more broadly, however, a BOC retreat would amount to an ominous sign for the global macro economy. That’s because Canada’s business cycle is intimately in line with that of its southern neighbor, the United States.

That 1.1% annualized decline in Canadian third-quarter GDP nets out as an increase of 1.3% in domestic demand is overwhelmed by a 2.4% drop on the external side. The U.S. consumes a commanding 79% of Canada’s exports, so the outsized weakness there appears to speak volumes about the precarious state of the world’s largest economy.

Canada real GDP - Domestic vs External Demand
Source: Bloomberg

The markets’ reaction to a dovish pivot from the Reserve Bank of Australia (RBA) just yesterday brought down the so-called “Aussie” dollar but also left local stocks with a loss on the day. This hints the markets are transitioning from celebrating incoming rate cuts in November to worrying about the malaise prompting them.

The sight of a defensive BOC within this context may then sound like a loudly shouted warning about the direction of global growth as demand in the U.S. unravels. That might bode ill for stocks at large—including on Wall Street—as well as cyclical commodities. The anti-risk Japanese yen and U.S. dollar are likely to rise against their peers.

Ilya Spivak, tastylive head of global macro, has 15 years of experience in trading strategy, and he specializes in identifying thematic moves in currencies, commodities, interest rates and equities. He hosts Macro Money and co-hosts Overtime, Monday-Thursday. @Ilyaspivak 

For live daily programming, market news and commentary, visit tastylive or the YouTube channels tastylive (for options traders), and tastyliveTrending for stocks, futures, forex & macro.

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