How to Play the Bank of Canada’s Easing Cycle

By now, the market has internalized that the Bank of Canada (BoC) still has some ways to go until it’s done with its easing cycle. In fact, there’s evidence within the recent spate of data that suggests that they might have to cut rates by more than the market is pricing in. For instance, the September inflation print was below the 2% target for the first time in almost four years. When taken with the vulnerable backdrop for household spending, a weakening labour market and slowing housing activity, it’s clear that the risks to the inflation outlook are to the downside.

That points to a resting spot for the BoC policy rate that is likely closer to 2.00% when this easing cycle is concluded. That’s well below the bank’s own estimate of where the neutral rate resides—which is closer to 2.75% (the middle of the 2.25%‒3.25% range). Indeed, it feels like the BoC will need to take administered rates into stimulative territory at some point in the coming years.

For the market, that means front-end yields should move lower, and that the curve overall should continue to steepen as the long end remains driven by supply/demand dynamics as well as spillover effects from the U.S. But what does this mean more practically? How should we expect yield-sensitive investors to react from here?

Our first inclination is that this should lead such investors to either:

• Shift their investments into funds that track yields further down the curve (i.e., “terming out”); or,
• Move into dividend-focused solutions that offer more attractive cashflow in a lower interest rate environment.

To better understand which of these paths is more likely, it helps to go back and look at investor behaviour starting from early 2022 and into 2023. Recall, that is when the BoC started hiking rates aggressively to address elevated inflation in the aftermath of the COVID-19 recovery.

Using available data on the liability side of the aggregate balance sheet for chartered banks in Canada, we can see a few clear trends during 2022-2023 (see Chart 1).

First, following a pronounced shift higher in the aftermath of the COVID-19 shock, chequing/savings and notice deposits declined as the fundamental backdrop improved and yields became more attractive in the money market and GIC space. Second, we witnessed a large shift up in fixed-term deposits as the BoC continued to hike interest rates. Remember that these are basically deposits at financial institutions with a specific maturity date in the form of Guaranteed Investment Certificates (or GICs). And finally, third, there was an increase in assets held in money market funds.

Chart 1 – Changes in Investment Flows Over Time in Canada

Source: Bank of Canada, as of September 30, 2024.

The shift toward GICs and money market fund products made sense in an environment where the yield curve was inverted. Indeed, flows kicked into higher gear once we saw the 3-month/10-year CAD curve flatten aggressively into the summer of 2022 (Chart 2).

Chart 2 – CAD 3-month/10-year Yield Curve

Source: BMO Global Asset Management, as of September 30, 2024.

However, if we are headed towards an environment whereby BoC policy rates are going to be ‘stimulative,’ then the CAD 3-month/10-year curve will almost assuredly continue to steepen back into positive territory. In fact, we have starting to see this curve re-steepen over the past several months. At the margin, that should reduce the appeal of money market and GICs for yield-sensitive investors.

If this continues, that implies that the funds that have accumulated in GICs and money market funds will most likely shift lower in the coming years. We can even estimate the pace at which this could happen. If we assume that the sensitivity of flows into GICs and money market funds is the same as it was in 2022 and 2023, then Chart 3 and Chart 4 give us an estimate to work with. Chart 3 shows the relationship between the 1-year GIC rate and the total amount held in fixed-term deposits, while Chart 4 does the same for the 3-month CAD Bill yield and money market funds.

Chart 3 – The Relationship Between Funds Held in GICs and the 1-Year Interest Rate

Monthly observations to 2010. Source: BMO Global Asset Management.

Chart 4 – The Relationship Between Funds Held in Money Market Funds and the 3-Month CAD Bill

Monthly observations going back 10 years. Source: BMO Global Asset Management.

For Chart 3, if we assume that the 1-year GIC rate will average a 75 basis points (bps) discount to the BoC’s overnight rate (which is a fair assumption given historical spreads), then a potential easing cycle that takes us towards a 2% rate would imply a 1.25% 1-year GIC rate. That would then equate to a ‘fair’ estimated level for total funds held in GICs at around C$378 billion. This implies a C$360 billion outflow into other products given where current levels likely are as an upper-end estimate.

If we do the same type of work for Chart 4, we estimate a C$20 billion of outflow from money market funds between now and when the BoC reaches 2%.

The question to ask is, where this flow will go. Of course, some of it will find its way back into chequing, savings, and notice deposits–but we don’t envisage total funds held there being higher than where it is now. There are too many products out there offering yield relative to where we were pre-pandemic. Some of it could also be ‘sticky’ and remain within the GIC/money market fund space. Nevertheless, we do envisage yield-sensitive investors will be more apt to vote with their feet if they see higher yields elsewhere, whether its through increased allocation to duration or towards solutions that offer more attractive yields.

We can make an informed estimate by looking at the suite of BMO ETF products at what has been happening with fund flows over the past several years.

Table 1 shows the relationship between the “spreads” (or the difference between the annualized distribution yield of the relevant ETF and benchmark 1-year GIC) and the fund flows for that ETF over the course of that time frame. The second column replicates this—but replaces the 1-year GIC rate for the 3-month CAD bill. We’re only considering ETFs here that are attractive due to their yields and are geographically focused on Canada. Also, we’re assuming that the degree of ‘yield sensitivity’ will be similar over the easing cycle.

From Table 1, a few things should be evident off the cuff. For one, we can dismiss the ETFs with negative correlations. Since we’re subtracting both the 1-year GIC rate and 3-month CAD bills from the annualized distribution yield (ADY), the correlation to fund flow should be positive (a higher ADY would mean fund flow is positive). Second, the strongest correlations are with the BMO Canadian High Dividend Covered Call ETF (Ticker: ZWC) and BMO Canadian Dividend ETF (Ticker: ZDV). Both of those are dividend focused strategies that imply a higher degree of sensitivity relative to other ETFs that track fixed income or those that are more sector focused.

What’s the takeaway here? In our minds, the best way to prepare for an environment in which flows will migrate out of fixed deposits and money market funds is to consider dividend-oriented strategies. To us, both ZWC (which is available in a mutual fund wrapper, the BMO Covered Call Canada High Dividend ETF Fund) and ZDV are the most suitable for this. An additional kicker is that dividend products are eligible for advantageous tax treatment compared to interest income-producing investments.

Table 1 – Correlations Between Spreads and Fund Flows

Correlations are monthly observations going back 5 years (September 30, 2019‒September 30, 2024). Source: BMO Global Asset Management.