News & analysis

Following yesterday’s rate statement, Governor Macklem today appeared in front of the Canadian Chamber of Commerce to give what was essentially a post statement press conference.

Reiterating themes struck in the rate statement yesterday, Macklem gave markets the green light to expect that the Bank’s quantitative easing programme will be the marginal tool used throughout this recuperation phase, the period likely denoting the next few quarters.

While the recovery slows and becomes uneven throughout the period of colder weather, where many expect covid cases to naturally rise, the Governing Council has signalled that another wave of balance sheet expansion is likely.

This provided markets with the natural answer to the question raised over the last few weeks, caused by the Bank’s acceptance to let maturing Treasury bill purchases roll off of its balance sheet, thus netting off its sovereign debt purchases and keeping the Bank’s total assets level. It is now clear that this policy was implemented in order to provide the central bank ample room to “calibrate” policy during this recuperation period, while mitigating the risk of the engulfing too large of a share of the market. This was eluded to in yesterday’s rate statement, but confirmed by Governor Macklem in today’s Q&A session.

While much of the above runs in line with our expectations coming into the event, which can be read in last week’s ‘Week Ahead’ document, a few additional points were made by Governor Macklem in today’s Q&A with journalists after the speech to the Chamber of Commerce.

 

Inflation

In response to the questions around the BoC adopting an average inflation target (AIT), akin to that recently introduced by the Federal Reserve, Governor Macklem stated that it will closely observe the effectiveness of the Fed’s new framework but at present, there is no clear alternative to the current regime. This will come as quite an obvious assentation to those that have followed the Bank’s survey of Canadian Consumer Expectations. In the survey, inflation expectations are closely monitored and actually rose in Q2’s release for the one-year horizon from 2.5% to 2.8%. This compares with inflation expectations in the US which have steadily drifted lower after disconnecting from the 2% anchor. With AIT aiming to push inflation expectations back towards the 2% anchor in the US, it is unreasonable at present to expect the BoC to shift its current framework considering how effective the current regime is at maintaining healthy inflation expectations. However, a framework review is currently underway and will be concluded in 2022. Even though the BoC is unlikely to shift towards an AIT regime in our opinion, the Governing Council will likely look through any transitory inflation overshoot while the output gap remains wide. While this may sound similar to the AIT framework, it doesn’t blur the line quite as much and retains the responsiveness of the central bank’s reaction function towards the back-end of the recovery. As Governor Macklem rightly pointed out, it is too early to discuss policy normalisation, especially with such uncertainty surrounding the recovery during the recuperation phase. That being said, markets are forward looking and, therefore, analysts must be too.

Policy normalisation is likely to lead with the end of balance sheet expansion, and potentially the tapering of the BoC’s balance sheet – although if the post GFC recovery is anything to go by, the latter is harder to achieve than initially suggested.

This will be the first hurdle for markets to grapple with, especially if the Federal Reserve meets our expectations and provides forward guidance on its balance sheet operations next week or in the November meeting once the framework review is concluded. The emphasis will then be placed on the Bank of Canada to provide more clarity on the phrase “until the recovery is well underway”. Markets already know that the BoC will use its balance sheet as its marginal policy tool over the coming periods, but at what point will they say enough is enough and leave space on the balance sheet for future shocks? Given the uncertainty over the economic recovery throughout the winter months, the Bank is unlikely to give any further clarification to the phrase “well underway” in order to maintain flexibility to its QE programme. The question thus remains, where does this divergence in forward guidance leave the loonie in the interim?

 

Canadian dollar

The strength of the Canadian dollar leading up to this week’s events was another area we expected the Bank of Canada to reference. Previous meetings in October 2019 and January 2020 saw the central bank verbally weaken the currency around the 1.31 level as the economy suffered a period of stagnant growth. With USDCAD trading at similar levels leading up to today’s press conference, we expected a tip of the hat by Macklem to currency markets. The acknowledgement of how FX markets are trading by central bankers has been a growing theme of late. Starting with the Reserve Bank of New Zealand and then the European Central Bank, who was embroiled in controversy during today’s meeting over the topic, central bankers have started to highlight the risks a strong currency poses to the economic recovery via the current account. The Bank of Canada, although recognizing this risk in a more relaxed manner than the RBNZ and ECB, is now no exception. The solution to the problem of a strengthening currency also comes in the form of an expansion in the QE programme. This is an area in which the recalibration of the QE programme could take a less obvious focus in the coming months. That being said, the playbook tried and tested by central bankers around the world is first to step up verbal intervention. The BoC could use the threat of ramping up QE to effectively soothe the traction seen in FX markets should the loonie take another leg higher, shaking some of the long positions out of the market at the BoC’s given tolerance level and effectively placing an upper limit on future loonie rallies. In the short-term, we place the Bank’s sensitivity to an overtly strong currency at the 1.29 level in USDCAD.

 

Housing Market

Similar to what is being seen around the globe, Canada’s housing market continues to be robust to the pandemic. However, Governor Macklem today highlighting that the source of house price growth is driven by pent up demand created by the lockdown period in Q2. The longer-term drivers of house price growth – a solid labour market generating strong wage growth, resilient credit growth, and a robust economic outlook – are missing from the current picture. The housing market is a major concern of the central bank’s, and rightly so. High levels of household debt-to-GDP place another vulnerability that could derail the current trajectory of the economic recovery should house prices start to dip. The Bank has recently slowed the pace in which it purchases mortgage-backed securities, back down to the benchmark C$500m a week, but this is another area in which the balance sheet expansion could focus on during its recalibration if needed.

 

USDCAD in the long-run

While this wasn’t discussed by BoC or Governor Macklem in either events over the last two days, it is a question that remains top of mind given the Fed’s shift towards AIT. The shift towards average inflation targeting means the Fed’s sensitivity towards an inflationary overshoot during the recovery stage will be lessened, removing a source for USD strength in the interim. Should the recoveries align such that inflation has overshot in Canada and the output gap has normalised also, the Bank of Canada is likely to lead the Fed in hiking rates in this scenario. The widening interest rate spread will lead to a surge in the Canadian dollar up until the Fed effectively reaches its average inflation target. Even though markets have little information over the length in which this average is gauged, it is reasonable to assume that once the 2% AIT is achieved the Fed will begin to hike rates in a much more aggressive manner than previously seen. This serves two purposes. Firstly, it cools the inflationary pressure in the economy and thus doesn’t cause a spiralling effect of high inflation. Secondly, it will allow the Fed to adjust away from its effective lower bound in a risk management setting, providing room to cut rates in the event of future shocks without entering into the unknown that is negative rates. The greenback is likely to exhibit an even sharper rally from policy normalisation at the back-end of the recovery than previously exhibited in this scenario, potentially causing increased volatility in USDCAD during the normalisation phase. However, by current projections, this won’t be occurring anytime soon. This scenario also hinges on the premise that the recovery in the respective economies will align, which at present is a very loose assumption.

 

Metric to watch: After today’s comments, the BoC’s balance sheet will be closely watched by markets to judge policy calibrations

 

Loonie weakens as Macklem highlights that QE will likely be ramped up and that the BoC is monitoring the strength of the currency

 

 

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