Bets on Canada rate cut hold out hope for lagging banks

INVESTORS up and down Toronto’s Bay Street are increasingly betting on a June rate cut in Canada, potentially giving a boost to Canada’s long-suffering bank stocks.

The S&P/TSX Banks index has gone up just 0.9 per cent this year, compared with a 6.7 per cent gain for Canada’s benchmark S&P/TSX Composite, amid concern that a combination of high interest rates, a wave of mortgage renewals, and rising loan losses will challenge the group. The dynamic is not new – over the past five years, the banks index has gained 19 per cent, about half of the 37 per cent surge of the broader Canadian stock gauge.

Now there’s reason for optimism for Canada’s largest market sector as a cooler-than-expected inflation report in May led analysts to bump up the chances of a June rate cut to 65 per cent from 40 per cent just a week earlier. Investors have long expected Canada’s central bank to lower rates ahead of the US Federal Reserve, given the high indebtedness of Canadian households and slower growth.

“What the rate cuts will mean for an economic outlook is much more positive,” Jefferies analyst John Aiken said. “Given the Canadian banks are a beta play on the Canadian economy, anything that helps the Canadian economy will be beneficial to their bottom line.”

Earnings season

Banks can expect some relief as the first rate cuts roll in, easing their cost of funding, Aiken said. While some loans will be repriced in tandem with a lower policy interest rate, they will still have a higher rate compared with two years ago. Even if it’s a moderate impact, it’s still a beneficial one, he said.

Bank of Nova Scotia is the next Big Six bank to report results on Tuesday (May 28) before North American markets open. Toronto-Dominion Bank managed to come ahead of analyst expectations in its results last Thursday.

Still, a recent rally in bank shares means the potential upside from a rate cut is already priced in, said IG Wealth Management chief investment strategist Philip Petursson.

“I certainly wouldn’t be trading on the potential for a Bank of Canada cut to say, ‘Oh, this is gonna provide a meaningful lift for financials,’” he said.

Other are more optimistic though. A rate cut would provide a sentiment lift for the Canadian banks, according to Greg Taylor, chief investment officer of Purpose Investments. It would help “stave off or make less severe the housing problems”, he said.

Last week, Canada’s banking regulator warned of a payment shock faced by homeowners who are renewing their mortgages and may be faced with the prospect of their interest payments rising dramatically. The Office of the Superintendent of Financial Institutions warned that 76 per cent of outstanding mortgages as at February are coming up for renewal by the end of 2026.

The longer rates stay elevated, the more strain these households will find themselves under, representing a risk to the banks that hold these mortgages. Peter Routledge, the superintendent of financial institutions, characterised the wave of upcoming renewals for variable-rate mortgages with fixed payments as a “mouse in the snake” – an issue banks will have to digest. BLOOMBERG