Today’s Bank of Canada rate announcement saw the central bank maintain their current policy stance despite the near-term deterioration in the economic outlook, highlighted by the Bank’s expectation of negative growth in Q1 this year.
While Governor Maklem stated that the latest lockdown measures put the economy in a deeper hole than expected in October, the near-term deterioration was offset by an upwards revision to the 2022 GDP forecast, which owes itself to the earlier than expected distribution of vaccines. While the fluid nature of the recovery depends on vaccine developments and the ability for authorities to safely reopen the economy, the Bank of Canada effectively used the GDP forecasts to strike a cautiously optimistic tone and stave off market expectations of mini rate cuts in response to the Q1 shock. This allows the Governing Council optionality going forward. The amount of options available to the BoC continued to be a theme of the meeting. While Governor Macklem was quick to highlight the other tools in the BoC’s toolbox that could be rolled out in response to another downturn in the economic outlook, markets are fully aware that a reduction in the effective lower bound is the most likely and impactful of the options should the outlook deteriorate further. For now, the BoC’s reluctance to highlight this or even discuss publically any developments on the review of the effective the lower bound resulted in fixed income markets trimming expectations of further rate cuts. This gave the loonie the green light to continue its rally and touch fresh 33-month highs, while Governor Macklem did little to talk down the strength of the currency in the press conference.
Additionally, despite Governor Macklem stating that it is too early to talk about tapering the BoC’s QE programme, market participants are continuing to ask the question with their actions. The latest rise in Canadian front-end yields in response to the lack of a mini rate cut today won’t go unnoticed by the BoC, especially as their average purchase maturity drifts further out along the curve. Speculation is rife about QE tapering in general, largely due to comments by Fed officials last week, but the BoC can’t carry on going forward without providing further forward guidance on the matter.
We believe in the coming two meetings, a clearer definition of “the recovery is well underway” will be delivered by the Governing Council, conditional on Covid and vaccine developments providing greater clarity for the economic outlook.
How the Governing Council provides this level of forward guidance is unknown, but outcome-based forward guidance is the likelier of the two options given that it is favoured by the Federal Reserve. In our view, given the current trajectory of the economic recovery, the pace of bond purchases is likely to slow towards the end of the year, with the Bank announcing that the balance sheet will stop expanding at some point in the first half of next year.
In summary, the Bank’s cautiously optimistic tone was well received by markets, as displayed by the percentage point rally the loonie posted just prior to the press conference.
For now, mini rate cuts are seemingly off the table unless additional downside risks prevail, but they could reemerge within the conversation during the early part of the recovery phase to introduce additional credit stimulus in a similar vein to how other central banks view negative rates. Going forward, USDCAD will continue to focus on Covid-19 developments both domestically and in neighbouring trading partners and remains at the mercy of the broad risk sentiment within markets. However, pressure from the possibility of lower rates in Canada is likely to clear the path for the loonie to push higher, should domestic and global economic conditions allow.
USDCAD hits lows not seen since April 2018 as the BoC avoids explicit discussion of further rate cuts
Bank of Canada’s latest forecasts:
Source: Bank of Canada January Monetary Policy Report
Author: Simon Harvey, FX market analyst