Weak GDP data signals end of BoC rate hikes, markets price 91% odds of hold

Canada's economy contracted in the second quarter, and the financial markets responded within minutes. The news arrived Friday morning: gross domestic product had shrunk at an annualized rate of 0.2%, a shock that upended expectations and reset the betting odds on what the Bank of Canada would do next week. By 8:40 a.m. Eastern time, credit markets had already recalculated. The probability that the central bank would hold rates steady at its September meeting had jumped from 79% to 91%.

The weakness was broad and unexpected. The Bank of Canada itself had forecast growth of 1.5% for the quarter. Economists surveyed ahead of time had expected 1.2%. Instead, the economy contracted. Statistics Canada traced the decline to several sources: housing investment fell sharply, inventory accumulation slowed, exports weakened, and household spending barely budged. The month-to-month picture was no better. July's preliminary estimate showed GDP essentially flat after a 0.2% decline in June. Earlier quarters were also revised downward—May's growth was cut from 0.3% to 0.2%, and the first quarter's annualized pace fell from 3.1% to 2.6%.

The timing mattered enormously. This was the last major domestic economic report before the Bank of Canada's policy decision. Markets had been pricing in a one-in-five chance of another rate hike. The GDP numbers erased that possibility almost entirely. The swaps market, which reflects the collective bets of traders and investors, now showed the central bank holding its overnight rate at 5% with overwhelming confidence. Beyond September, the repricing was even more dramatic. Markets that had assigned roughly even odds to further hikes through 2024 now saw rate cuts as increasingly likely by spring.

Economists quickly weighed in on what the data meant. Stephen Brown at Capital Economics noted that the second-quarter contraction left little doubt about the Bank of Canada's next move. More troubling was what it suggested about the broader economy. With June's decline and July's stagnation, he wrote, Canada may already have slipped into a modest recession. The weakness in consumer spending was particularly telling—it had grown just 0.2% annualized in the quarter, a sharp deceleration from the 4.7% pace in the first quarter. That slowdown suggested households were finally feeling the weight of higher borrowing costs. Housing investment had plummeted 8.2% annualized, likely driven by a collapse in renovation spending. Even accounting for temporary drags—wildfires had hurt agriculture, forestry, and mining in May and June—the underlying momentum looked fragile.

Katherine Judge at CIBC Capital Markets offered a similar assessment. The contraction made a rate hike next week "very unlikely," she said. The drop in housing investment, combined with slower inventory accumulation and sluggish exports, painted a picture of an economy losing steam. Consumer resilience, which had surprised many observers through the first half of the year, appeared to have finally cracked.

The path forward hinged on a narrow margin. For Canada to avoid another quarterly contraction in the third quarter, GDP would need to grow 0.1% month-over-month in both August and September. Brown remained skeptical that would happen. Wildfire disruptions were expected to persist through August, and forward-looking surveys suggested continued weakness. His forecast was for another quarterly decline. The question now was not whether the Bank of Canada would raise rates again—markets had settled that—but whether the economy was already in recession and how much further it might fall.