A rebound in economic activity, an uplift in inflationary pressures and a firming crude oil market would normally provide the perfect concoction for a hawkish Bank of Canada (BOC), but not this time. The reason: an uncertain global economic outlook.
Uncertainty in the Global Outlook
While for now this remains a cursory problem for both the loonie and fixed income markets, it will undoubtedly rear its head again in a more vicious fashion in the future – especially if the global macro climate worsens.
For this reason, we believe Governor Poloz will need to tread carefully in Wednesday’s meeting to keep the status quo and prevent stoking market expectations for future monetary policy, especially given fixed income markets recent sensitivity to central bank meetings.
An extension in the current neutral stance also provides flexibility for policy, keeping the door open for potential rate cuts should the external climate deteriorate while not making it a foregone conclusion.
Chart 1: Markets are pricing rate cuts in the US far more aggressively than in Canada
Current market pricing implies a 25 basis point cut by the Bank of Canada in the coming 12-month period. This is broadly in line with G10 pricing given the firming economic conditions in Canada, however, in a time where a global synchronised cutting cycle is expected markets may have under-priced the BoC’s monetary policy stance.
Expectations of rate cuts by the BoC could easily increase given a downturn in domestic economic data or a further slowdown in the global economy.
The latter looks the most probable downside risk, especially as the US-China trade war drags on, and would have a two pronged impact on the Canadian economy via oil markets and the trade balance. For this reason, Poloz has room to surprise to the dovish side on Wednesday.
With no rate cut in 2019, the loonie looks set to break $1.30. That being said, the effect of a slowing global economy will take some time to appear in Canada’s economic data, reinforcing our belief that a dovish shift by the BoC will not result in a rate cut in 2019.
In addition to the deteriorating macro climate, the BoC will be more than aware of narrowing US-Canada yield spreads.
If conditions deteriorate in line with the current market expectations, prompting a series of rate cuts by the majority of G10 central banks, Canadian bond yields could be the highest in the developed market space as early as December.
While this supports an extended CAD rally far below the $1.30 handle against the US dollar, a stronger loonie will begin to test the Bank of Canada’s resolve.
Such an occurrence could become problematic in the medium-term, especially given the BoC forecast for a moderation in growth in 2020.
Chart 2: Data surprises in Canada and the US diverge the most since 2008, supporting a neutral Bank of Canada in the short-term and a sustained loonie rally.
Bank of Canada outlook
For now, a stronger domestic economy will give the BoC a substantive reason to remain on hold, but the central bank sits in a precarious position as it faces a juggling act between diverging domestic and external conditions.
The global trade environment could swing it either direction and while US-Sino relations show promising signs for a breakthrough, market participants will be aware that another breakdown in relations is only a tweet away.
We agree with the market pricing that the BoC will partake in a singular 25 basis point cut, but our base case for a rate cut is skewed towards the beginning of 2020.