Canadian recession likely to drive another rate cut

Canadian forecasters have consistently underestimated the impact of the sharp decline in oil prices on the Canadian economy. As recently as May, the consensus view was that real GDP growth wouldn't fall into negative territory, though it would be greatly hampered by the pullback in investment in the energy sector. The Bank of Canada was no exception, with its April Monetary Policy Report (MPR) suggesting growth in the first half of 2015 would average around 1%.

Q1 real GDP growth surprised on the downside, contracting by 0.6% (annualized) as opposed to an expected 0.3% expansion. There is now a risk that Q1 will be revised even further into negative territory. Following a barrage of negative economic releases, growth in April real GDP (-0.1% m/m) also came in below consensus (+0.1%). 

The economy is tracking well below the 1.9% pace expected by the Bank of Canada in its April 2015 MPR. Indeed, growth in H1 2015 is likely to be roughly 1.8 percentage points below the Bank's latest forecast, estimates TD Economics. In the absence of another interest rate cut, this means it could take a year longer than the Bank of Canada expected for the Canadian economy to return to its trend level of output. With this in mind, the balance of probabilities has tipped in favour of another quarter-point rate cut at the Bank's next interest rate announcement on July 15, adds TD Economics.

The implications of an interest rate cut will be multifold. Canadian 2-year bond yields are likely to edge lower by 10 to 15 basis points, causing the spread to their U.S. counterparts to widen with the Federal Reserve expected to start raising rates in September. 

"This will also reinforce our view that the Canadian dollar will be sustained below 80 cents through the second half of this year. The lower loonie should benefit exporters, while a further decline in borrowing rates is likely to spur renewed housing market activity", says TD Economics.