07:47 AM EDT, 08/02/2024 (MT Newswires) -- since we're not ready to pencil in a recession just yet, the extent of the moves will be limited by the policy rate falling just 50bps below our neutral rate estimate (Chart). In a recession, the policy rate has tended to fall 250 to 300bps below neutral. Because we still see a path for the Bank of Canada to achieve a soft landing, we don't view such a dramatic decline in rates as necessary.

The extent to which the central bank cuts rates relative to the neutral rate estimate has important implications for the shape of the yield curve (Chart). The neutral rate provides an anchor for longer-term interest rates. So moving too far below means that curve steepening will be limited relative to past cutting cycles (Chart).

Also containing the steepening trend globally will be cash flowing from term deposits and money market funds into the longer end (Chart). Central bank rate cuts will work to make the yields on short-term debt instruments less attractive both in absolute terms and relative to securities with longer tenors. As cash migrates further out the yield curve, term premiums should remain contained.

All that being said, the magnitude of this easing cycle could be greater than we currently envisage if a domestic or global recession hits. Should a downturn take hold and begin to snowball, central bankers will need to cut rates more forcefully than what's accounted for in our base case forecast. That would lead to lower rates across the curve and also a steeper curve, as the policy rate falls further below neutral. For now, we believe central bankers are on the right track and can narrowly avoid a recession, meaning our base case forecast remains the most likely outcome with a recession just a downside risk.