Why the Bank of Canada pausedDec 11, 2018

Chart fang and SP performance july 2018

The Announcement

Last Wednesday markets were surprised by the dovish nature of the Bank of Canada’s (BoC) commentary related to their interest rate decision to maintain policy rates at their current levels. They highlighted some challenges to the Canadian economy on a few fronts.

First the negative effects to the energy sector from a) a prolonged weakness in Canadian oil prices relative to world oil prices and b) the surprise decision by the Alberta government to force a production cut in crude output to support prices. This will likely have a negative effect on output, investment and contribution to overall Canadian GDP from that sector. The BoC also commented on the negative effect from trade spats on global demand, of course an issue for an exporter like Canada. Finally, they highlighted concern that inflation will ease in coming months allowing more room for non-inflationary growth to extend the cycle. It looks like many more concerns lie ahead!

Rate Path

The statement did say that the BoC still plans to move rates to the “neutral” range (i.e 3 more hikes) to bottom end of current range estimate. However with the Bank of Canada looking likely to join the Federal Reserve (FED) in becoming more data-dependent and, given the challenging backdrop highlighted above, there is little urgency to get there quickly.

Chart 3 year global manufacturing performance

The market is now only pricing in 23bps (about 1 hike) for 2019, which is down significantly from just a month or two ago when expectations were for 60bps of hikes (pushing close to 3 hikes).

Chart 3 year global manufacturing performance

Interest Rate Sensitivity in Canada

Interest sensitivity is high in Canada due to elevated debt levels and frothy housing markets. Macro-prudential policy seems to be cooling housing, which is taking some pressure off BoC to raise rates to counter a potential bubble. The previous rate hikes are still having an effect as mortgage rates and debt service costs continue to rise. This has led to some cooling of house prices (but by no means crashing). This takes some pressure off the BoC to push rates up too much higher.

Chart 3 year global manufacturing performance

Bottom line

Marginally adding back to duration in our portfolios this year was a good decision but we feel the market is already moved a long way towards discounting a more dovish BoC (and FED for that matter). So the time to increase duration exposure will come in the future at better levels than we see today. We think maintaining current allocations (still underweight duration) makes sense for now.

Chart 3 year global manufacturing performance

Looking at Canadian equities, the valuation gap between Canada and the US remains at a fairly high level, which historically has suggested some or much of the bad news is already priced into the Canadian equity market. We upgraded and added back to Canadian equities to a slight overweight a few months ago. I will take a deeper diver into Canadian equities in a future post, stay tuned.

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.