By Douglas Porter

December 20, 2024

The financial market rally that had been the hallmark of 2024 has run into some heavy weather as the year draws to a close. Prior to a big Friday rebound, the struggle was best characterized by the Dow’s 10-day decline, a streak not seen since 1974. The immediate and obvious trigger this week was the Fed’s more cautious outlook on the pace of 2025 rate cuts, as policy moves into a “new phase” after this week’s 25 bp slice. But can anyone really be surprised that the Fed has turned coy? U.S. GDP growth continues to roll along close to a 3% pace, core inflation has been a bit sticky in recent months, and there is monumental uncertainty on the fiscal policy front—accentuated by the collapse of the spending agreement, and now the real possibility of a government shutdown.

Apparently, the market saw none of this coming, fixating on the FOMC’s dot plot shift to just 50 bps of cuts next year (from 100 bps previously). We’ll note that over the dot plot didn’t actually manage to get the rate call right for 2024 until the Autumn, whereas BMO Economics was calling for 100 bps of cuts, all in the second half of this year—correcto-mundo—since late 2023. Still, the back-up in yields resumed, with 10-year Treasuries rising almost 10 bps on the week to finish around 4.5%, while 2s nudged up a few bps to almost 4.3% even with a Fed rate cut and a friendly core PCE reading (up just 0.1% m/m). Thus, 10s are up 60 bps this year, even as the Fed has cut 100 bps, taking the yield curve from deeply inverted to upward sloping.

The sell-off in bonds and the prospect of fewer rate cuts next year rattled equities, which were already wobbling after a powerful run. The S&P 500 dropped more than 1%, falling back below 6000 and washing away most of the post-election rally. It’s a similar picture for the TSX, which has dropped for 8 of the past 9 sessions and is back to early November levels. (Before amping up the gloom, we would note that with a Friday bounce the S&P 500 is still up 25% this year and the TSX has been close by with an 18% gain.) Even gold and crypto currencies, which had feasted recently, were hit hard by a more cautious Fed and the general pullback in sentiment.

Beyond the Fed, markets are also dealing with profound policy uncertainty in general. The U.S. fiscal outlook is clouded not just by the near-term threat of a shutdown—now with some debt ceiling drama adding spice—but by the more existential threat of a $2 trillion budget deficit. We have long suspected that fiscal policy will not provide any net growth boost in 2025—new tax relief will take time, and will likely be paid for by spending cuts. And, it’s pretty clear that there will be some real effort to rein in government outlays, especially after a 10% jump this year.

Finally, investors are also grappling with the absolute wildcard of U.S. trade policy. While the conventional wisdom is that the incoming President’s audacious threats are mostly bluster, no one can be truly sure, and there are plenty of indications that the risk is much more serious than in the first Trump Administration. There is massive debate over just how inflationary tariffs could be for the U.S. economy, but the direction is clear—higher—and there’s no debate on the tariff impact on growth—lower. Thus, increased protectionism is negative for financial markets, while powering the U.S. dollar. A higher greenback is the one aspect of the Trump Trade that rolls on relentlessly, with the dollar index now up almost 8% just this quarter.

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The flipside of the strong dollar has been misery for the loonie. While not especially weak against other currencies (Chart 1), the US$ exchange rate matters much more to the Canadian economy than others, given the heavy weight of two-way Canada/U.S. trade. After holding mostly steady in a narrow range through the first 10 months of the year, the Canadian dollar has sunk 4% just since the U.S. election, drooping below 70 cents for just the third time in the past 20 years. To be sure, we’re still a long way from the record lows of 61.8 cents (or $1.618/US$—love the symmetry!) in early 2002, but the deep sag threatens to stoke smoldering inflation, and will likely damage already weak consumer sentiment.

The pressures on the currency are well-known: First, a strong U.S. dollar generally is driving down everyone. Second, the Bank of Canada’s uber-aggressive 175 bps of rate cuts was always a clear risk to the loonie, further endangered by the Bank’s loonie-faire stance on the exchange rate. Third, the looming threat of 25% U.S. tariffs has added to the pressure. If that steaming cauldron wasn’t enough to cook the loonie, how about a little domestic political intrigue for an eye of newt? Or how about a lot? Chrystia Freeland’s sudden decision to step down as Finance Minister on Monday—the very day of the Fall Economic Statement—sent shockwaves through Ottawa, casting more doubt on the government’s future, resulting in a full Cabinet shuffle, and culminating in a pledge by the NDP to vote to bring down the government—an early 2025 election now beckons.

Overshadowed by the high political drama was the mundane news that Canada’s fiscal situation has weakened since the spring budget—no real surprise there, we must say. Deficits now weigh in closer to 2% of GDP for the past and current fiscal year (averaging $55 billion), versus the prior plan of closer to 1% (or about $40 billion). Yet, the debt/GDP ratio is no worse for wear at around 42%, thanks to a big upward revision to GDP. We suspected that the near-term policy outlook would not materially shift under new FM Dominic LeBlanc, and now we face an election in any event.

While Canadian bond yields initially jumped on the news of Freeland’s departure, by week’s end they had essentially mirrored the rise in Treasury yields—so no discernible net market impact, even with the prospect of an election. However, it is fair to say that the deepening political uncertainty is just one more reason why traders are so down on the loonie as 2024 draws to a close. Lest you think that this is some kind of unusually traumatic year for the currency, note that there have been no fewer than seven other years in the past 50 that have seen the Canadian dollar weaken by 7.5% or more. Uncomfortable maybe, but it’s not unusual.

Douglas Porter is chief economist and managing director, BMO Financial Group. His weekly Talking Points memo is published by Policy Online with permission from BMO.