Inflation is falling, where does that leave fixed income & the Canadian economy?

Last week’s consumer price index (CPI) numbers showed a significant slowdown in Canadian inflation. Annualized CPI rose 2.9 per cent year over year, falling below the psychological 3 per cent threshold towards the Bank of Canada’s target rate. Core inflation, too, showed signs of coming slightly unstuck and falling towards manageable levels. While one datapoint does not a trend make, the news was greeted warmly by fixed income investors and Canadians hoping for the Bank of Canada to cut interest rates soon.

Allison Boxer, Senior VP and Economist at PIMCO, noted that her outlook for BoC rate cuts remains intact: she expects the central bank to cut around the middle of this year. She views the latest development as positive and highlights some of the opportunities now present on the Canadian fixed income market as a result. She outlined, as well, where inflationary pressures persist in the Canadian economy and what trends pension funds and plan sponsors need to be aware of as they prepare their members for a potential period of structurally higher inflation.

“If you take a five-year horizon, at PIMCO we call that our secular outlook, we say that across global developed markets there are secular trends like supply chain resilience, increased defense spending, and the green transition that will mean inflation trends a little bit higher post-pandemic than it was pre-pandemic,” Boxer says.

The area where Boxer sees Canada diverging somewhat from other developed economies is on shelter inflation. Canada is the only developed economy to include mortgage interest cost in its CPI numbers. That means shelter inflation may remain a thorn for Canadian CPI going forward. She notes that high immigration, low housing supply, and past interest rate hikes have made shelter inflation an ongoing concern for Canada. We don’t yet know where it will settle longer-term, though if cuts come when they are expected to that may take some pressure off, as would a slowdown in immigration or an uptick in supply. Nevertheless, Boxer sees a likelihood that shelter inflation settles higher than its pre-pandemic levels.

That does not mean that Boxer or PIMCO expect inflation to sit consistently at the astronomically high levels it hit in 2022. What they see is more of a marginal shift, running slightly higher than the bank’s target rate. While that higher rate of inflation may be somewhat manageable, it’s a concern for defined benefit pension plans and plan sponsors as they work to ensure their members can be sustained despite rising costs.

While that longer-term cycle points to a slightly higher trend in inflation, the current decrease does open up some opportunities for upside capture in fixed income. Speaking in broad terms she thinks the slowdown we’ve seen so far in the Canadian economy, especially relative to the US, makes cuts more likely. She notes, as well, that the BoC may soon see Canadian rates as sitting relatively far above “neutral” and therefore cuts may be a bit steeper, opening up capital appreciation opportunities in the bond market.

Boxer also notes that we are unlikely to see rates cut back to pre-pandemic levels, meaning the yields on fixed income at a neutral rate should rest slightly above even a marginally elevated rate of long-term inflation. Even if there remains an inflation risk premium on the yield curve, asset managers should be able to realize significant enough value on fixed income markets to sustain returns and cash flows above the rate of inflation. The trend towards real asset and alternative asset investments, too, may prove to be a useful inflation hedge should inflation persist at higher levels.

Boxer’s key takeaways from the CPI print and the overall trend in Canadian inflation is a positive one. She believes that the rate hikes of 2022 and 2023 have done their job, resulting in a notable slowdown of the Canadian economy. While secular forces may keep inflation somewhat higher than pre-pandemic levels, she thinks the new paradigm in fixed income markets as well as asset managers other source of returns can help deal with those challenges.

“We would emphasize that the Bank of Canada has significantly tightened monetary policy and we think it’s working,” Boxer says. “We’ve seen a much more notable slowing of the Canadian economy relative to the US and we think that puts the Bank of Canada in a relatively better place to start cutting rates later this year.”