Yield curve inversion turns up heat on BoC

‘CAN’T IGNORE’

Inversion of Canada’s yield curve by the most in nearly two decades is threatening to coerce the Bank of Canada to cut interest rates rather than risk an economic downturn, portfolio managers said on Thursday.

Curve inversion, when long-term yields dip below short-term ones, is seen by some as a harbinger of economic recession. It could also be a source of damage for the economy, reducing the incentive for banks to lend and the motivation for investors to take on the longterm projects.

“The Bank of Canada can’t ignore what’s happening in debt markets and the inversion of the yield curve,” said Sal Guatieri, a senior economist at BMO Capital Markets. “It’s so highly inverted now, a reduction in policy rates would at least provide some semblance of normality.”

The yield on the U.S. 10-year Treasury note tipped 2.1 basis points below 2-year Treasury yields on Wednesday, spooking global markets.

The Bank of Canada left overnight borrowing costs on hold at 1.75 per cent in July and said it was comfortable with that stance given the domestic economy’s recovery. The BoC’s position has put it at odds with many of the global central banks.

But Canadian long-term rates, which are linked to moves in the global bond market, have since fallen further below short-term rates. On Thursday, the 10-year yield traded at about 20 basis points below the 2-year yield, its deepest inversion since May 2000.

The last two inversions of 2- and 10-year rates, in 2000 and 2007, preceded sharp easing cycles.

“I think the BoC will be watching this nervously,” said James Athey at Aberdeen Standard Investments in London. “It’s very much a global phenomenon but the signs coming from markets, including inversion, are concerning.”

Investors across the world are worried trade conflicts could hurt the world economy. Canada runs a current account deficit and exports many commodities, including oil, so it could be hurt by a slowdown in the global flow of trade or capital.

“I think a global recession scenario is a strong possibility, and if so, it will be very difficult for Canada to escape a similar fate,” said Hosen Marjaee at Manulife Asset Management. “The BoC may have to start thinking about a cut sooner than later.”

A potential Bank of Canada rate cut could hurt the Canadian dollar, one of the top performing G10 currencies this year.

Money markets see about a 25-per-cent chance that the central bank will ease at its next interest rate decision on Sept. 4, up from 10 per cent last month. By December, a rate cut is almost fully priced into the market.

“The market is trying to bully” the Fed and other central banks, Athey said. “The market will win,” he added.