Canada’s Economy Unexpectedly Shrinks, Supporting Rate Pause

The Canadian economy is off to a weak start in the second half of this year after unexpectedly contracting in the second quarter, cementing the case for the Bank of Canada to hold rates steady next week.

(Bloomberg) — The Canadian economy is off to a weak start in the second half of this year after unexpectedly contracting in the second quarter, cementing the case for the Bank of Canada to hold rates steady next week. 

Preliminary data suggest gross domestic product was flat in July, as increases in the public, finance and professional sectors were offset by decreases in manufacturing, transportation and construction industries, Statistics Canada reported Friday in Ottawa. That followed a 0.2% contraction in June, matching the median estimate in a Bloomberg survey of economists, and a downwardly revised 0.2% expansion in May.

Overall, the economy shrank at a 0.2% annualized pace in the second quarter, far weaker than both a consensus estimate of 1.2% growth and the Bank of Canada’s forecast of 1.5%. That’s a deceleration from a downwardly revised 2.6% pace in the first three months of 2023.

Bond yields tumbled, with the benchmark Canada two-year sinking as low as 4.527%, its lowest intraday level since Aug. 8. The loonie dropped to C$1.354 per US dollar at 9:33 a.m. Ottawa time.

Traders in overnight swaps markets put the odds of another rate hike at around one in 10, compared with around one in four a day earlier.

Friday’s report suggest the central bank’s rate increases are slowing the economy by more than expected. Canada may already be in the middle of a technical recession, if output shrinks again in the third quarter.

The data paint a clearer picture of an economy that’s gearing down rapidly under the weight of 475 basis points of interest-rate increases, and will likely be enough to convince the Bank of Canada to hold rates steady next Wednesday.

“We are seeing the Bank of Canada actually getting some traction here with those rate hikes,” Dawn Desjardins, chief economist at Deloitte Canada, told BNN Bloomberg Television.

The second-quarter slowdown was due to continued declines in housing investment, smaller inventory accumulation, as well as slower international exports and household spending.

Governor Tiff Macklem and his officials forecast economic growth to moderate to an average of about 1% through the second half of this year and the first half of 2024. They expect higher interest rates to weigh on household spending and business investment, and weak foreign demand to restrain export growth.

Friday’s report supports that projection and suggests Canada’s economy has entered a softer patch. Growth in consumption spending is expected to slow over the second half of this year, as demand for rate-sensitive goods and services weakens and more households renew their mortgages at higher rates.

A hike at the central bank’s meeting next week is “very unlikely” now, according to Katherine Judge, an economist at Canadian Imperial Bank of Commerce. “Adding to the dismal report was the advance GDP estimate for July, which suggested a flat month for GDP, adding to the evidence that the Canadian economy does not need higher interest rates,” she said in a report to investors.

The unexpected strength of household spending and increase in exports earlier this year lifted economic activity and the labor market, and prompted the Bank of Canada to abandon its pause and raise borrowing costs in June and July to a 22-year high of 5%. Policymakers then viewed monetary policy as insufficiently restrictive and said greater excess demand were sustaining underlying price pressures.

Much of the data released on Friday captures the period before the central bank’s latest 50 basis points of rate hikes, said Tiago Figueiredo, a macro strategist at Desjardins Securities. “As a result, the GDP numbers reinforce our view that the Bank of Canada is done hiking.”

Second-quarter data suggest rates may already be high enough to slow down the economy and rein in spending by heavily indebted Canadian households.

Growth in real household spending slowed to 0.2% in the second quarter, the weakest pace in two years, from a downwardly revised 4.7% in the first quarter. But while aggregate household expenditures edged up slightly, spending per capita actually fell and had declined three in the last four quarters, suggesting rapid population growth may mask some of the weakness in the economy.

Services spending slightly contracted in the second quarter.

Rising wages and disposable income also weren’t enough to buoy spending. Compensation of employees rose 9.1% on an annualized basis, mainly due to higher average wages. Those gains also led to an increase of 10.7% in household disposable income, a reversal from the decline in the first quarter.

Growing drought and wildfires in many regions across Canada contributed to contractions in crop production, oil and gas extraction, mining, and activities in recreational vehicle parks and camps.

In June, both services and goods-producing industries contracted, with wholesale, retail and construction sectors seeing some of the largest declines.

GDP now needs to rise by 0.1% on a monthly basis in both August and September to avoid another quarterly contraction, Stephen Brown of Capital Economics said in a report to investors. “Given the ongoing disruption from the wildfires in August and the weakness of some of the surveys, we remain confident in our forecast that quarterly GDP will edge down again.” 

–With assistance from Erik Hertzberg and Derek Decloet.

(Updates with more economist reaction, freshens market moves.)

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