Canada's economy is flirting with recession and the downturn could worsen now that a period of rapid growth in the United States is expected to end, raising bets on the Bank of Canada shifting to interest rate cuts sooner than previously thought.
The Canadian central bank expects that the economy will avoid a recession, and last month forecast growth of 0.8% for both the third and fourth quarters.
Since then, preliminary data has indicted a shallow economic contraction for a second straight quarter in the third quarter. Analysts say that if U.S. activity slows, then the Canadian economy could shrink in the current quarter as well.
The BoC has said it wants to cool the economy just enough to bring down inflation, but it does not want policy to be so restrictive that it triggers a deep recession.
"According to established economic wisdom, when the U.S. sniffles, Canada tends to catch a cold," said Karl Schamotta, chief market strategist at Corpay.
"But with the world so reliant on American consumer demand, and the Canadian private sector carrying exorbitantly high debt levels, if the U.S. sniffles, Canada is going to get pneumonia."
Canada sends about 75% of its exports to the United States.
"One reason we expect Canada's economy to contract in the fourth quarter is that its major trading partner, the U.S., is expected to decelerate sharply," said Sal Guatieri, a senior economist at BMO Capital Markets. "That will hit Canadian exports."
The Federal Reserve Bank of Atlanta's running estimate of fourth-quarter growth in the United States is at 2%, down from a blockbuster pace of 4.9% in the third. BMO projects that U.S. growth will slow to 0.9% in the fourth quarter and that Canada's economy will shrink 1%.
The potential for further weakening in the Canadian economy is already evident in money markets. They have moved to price in a rate cut as soon as April after betting just last month that the benchmark rate would not be lowered from its current level of 5%, a 22-year high, before the end of 2024 and that the BoC may need to tighten further.
"The Bank (of Canada) has seemingly overestimated GDP growth for two quarters now, which implies that it is probably underestimating the impact of high interest rates on activity," said Stephen Brown, deputy chief North America economist at Capital Economics. Brown also expects a fourth-quarter contraction in the economy.
Support for the economy could come from government spending - some additional measures are expected in a fiscal update on Tuesday - and record levels of immigration, say analysts.
But productivity has tended to be a drag, falling in 11 of the last 12 quarters, and household finances are being squeezed as Canadians renew their mortgages at much higher interest rates after borrowing heavily during the pandemic to participate in a red-hot housing market.
"The Bank used to make a lot about this idea that consumers were well placed to cope with higher interest rates, but that idea is now being called into question given the weakness of retail sales volumes and renewed declines in house prices," Brown said.
(Reporting by Fergal Smith; editing by Jonathan Oatis)
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