The Bank of Canada plays catch-up, sort of.

The Bank of Canada (BoC) had been unique among global central banks with its more neutral domestic outlook and steady monetary policy in recent quarters while other central banks reignited quantitative easing programs and cut interest rates. On Wednesday, the BoC played a little catch-up shifting to a somewhat more dovish tone.

Decision & rationale

The BoC kept rates unchanged at 1.75% but shifted to a more dovish tone citing fears that Canada’s “economic resilience will be tested” and economic growth will fall below potential. They revised their expectations lower for domestic growth due to continued geopolitical and trade tensions weighing on business investment and confidence. The BoC does expect strong labour market conditions and a recovery in the housing market to offset some of the weakness. Federal fiscal spending programs may also provide a boost to the economy, though the effects will likely be delayed and somewhat offset by reduced spending at the provincial level. The stronger CAD was also cited as being a headwind to exports and competitiveness.

Parsing the verbiage

In previous announcements the BoC suggested that low Canadian rates were stimulative and the economy was operating close to full potential. This seems to have shifted somewhat, as now the BoC “is mindful that the resilience of Canada’s economy will be increasingly tested as trade conflicts and uncertainty persist”. This change in tone appears to open the door to a future cut(s) but by no means guarantees it.

After the announcement, the market’s probability of a January or March rate cut jumped up to almost even odds from about 25% pre-meeting:

A Key Concern

Investment has been a concern for Canada especially in the oil and gas sector. Given the minority Liberal government likely needing NDP (left leaning) support to govern, uncertainty will remain high in the oil and gas sector, which may continue to be a headwind for investment. The BoC does think however that trade-war related uncertainties and some other temporary factors will have less an impact on non-energy investment and exports in the year ahead. The CAD appreciating vs. non-USD currencies does make it harder for Canadian businesses to compete, so it’s interesting that the BoC mentioned the foreign exchange rate directly and may rationalize a rate cut in the near future.

Pockets of health

Housing and the consumer remain resilient and the BoC is watching these markets carefully for any signs of contagion from trade related risks, but the country is quite bifurcated with areas such as Alberta struggling on these fronts compared to other regions. The BoC talked about weighing the cost of an insurance cut(s) vs. creating froth in certain parts of the economy (like housing) but suggested that with the macro prudential rules in place, this was less a risk and inhibitor to a future cut(s).

Takeaway

By no means is a rate cut guaranteed, but should the environment deteriorate even marginally from here the BoC seems willing to provide an ‘insurance cut(s)’ to support growth. If we assume that Canada is bound by the 0% level on the lower end of their monetary policy rate, this does provide some flexibility to cut rates compared to other central banks who are arguably much closer to (or may already be at) their hypothetical lower bound.

Looking at the Canadian yield curve vs. other markets like Japan and Europe (shown below), Canadian government bonds (and US Treasuries for that matter) have relatively more room for capital appreciation in a downside risk scenario. Although we don’t expect the “Japanification” of the Canadian (or US) yield curve there is plenty of room to move in that direction in more difficult economic times.

Despite what are expensive valuations and low overall yields in developed market government bonds, Canadian government bonds should still provide a good buffer to a deteriorating economic environment and falling equity markets given the likelihood of the BoC cutting rates by more and quicker than market currently expects.

There is of course a lot of risk to developed government bond markets generally at such historically low yield levels. If we enter an environment of an improving macro backdrop (i.e. trade war detent) and bottoming of economic data, yields will rise from here. While some exposure to Canadian government bonds makes sense from a diversification and downside protection standpoint in a multi-asset portfolio, with richer valuations in developed market government bonds generally it is an asset class we don’t want to be overexposed to either.

Michael Greenberg’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

Important Legal Information

All investments involve risks, including the possible loss of principal. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions.