BEHIND the CURVE
EXPECT THE BANK OF CANADA TO RAISE RATES AGAIN, AGAIN — AND MAYBE EVEN AGAIN — ARGUES DAVID ROSENBERG AS IT PLAYS CATCHUP TO ITS BULLISH ECONOMIC VIEW.
The Bank of Canada has obviously done a complete about- face on its macro viewpoint. Back on May 24, the central bank shifted to a hard- neutral posture not long after the markets had begun to contemplate an easing in policy amidst the Home Capital debacle. That neutral stance morphed into a clear tightening bias in several speeches by senior monetary officials ( including bank governor Stephen Poloz himself ) just a few weeks ago. This inter- meeting tightening stance gave the central bank the leeway not only to raise rates for the first time in roughly seven years, but take the added step of providing a very clear signal of more rate hikes to come.
The Bank of Canada not only raised its GDP forecast for this year and next, but sharply bolstered its confidence level in these projections being achieved. Although there are still some concerns, they are not sufficiently problematic to keep the central bank on its prior ultra-accommodative policy setting. In fact, several prior concerns were no longer included and instead, the press statement was replete with highly bullish commentary on the economic outlook and the broadly based nature of the current and expected macro backdrop. Below-target inflation is viewed as a transitory phenomenon and most importantly, the Bank now expects the closely- watched output gap to close by the end of this year as opposed to the first half of 2018 as per the April Monetary Policy Report ( MPR) and the anticipated mid-2018 as per the MPR at the turn of the year.
The Bank has the luxury of having every inflation measure below target but even so, if it is anywhere close to being in the ballpark in terms of full employment being reached by year-end, the prospect of further rate hikes and further Canadian dollar appreciation is very high. In fact, an overnight rate that would ordinarily be consistent with a closing of the output gap given a roughly 4 per cent nominal GDP growth profile is certainly not anywhere close to 0.75 per cent, or one per cent for that matter. In other words, insofar as the Bank of Canada is confident in its view, it has quite a bit more work to do. That means a flatter yield curve, relative outperformance by the Canadian bank stocks, and a firmer currency ahead.
Sifting through the Monetary Policy Report, I was struck that even within the Bank of Canada’s new-found optimism over domestic economic prospects was an acknowledgment of near-term oil price weakness (though the Bank sees depleted investment growth in the industry leading to supply constraints later on and a rebound in crude); the recent correction in housing activity in south- central Ontario; U. S. trade policy uncertainties; and a removal of the assumed fiscal stimulus that was in the prior April forecast. So it’s not as if Poloz et al have their heads in the sand — they incorporated all the downside risks into the forecast and still found a way to end up with upward growth revisions to 2017 ( 2.8 per cent from 2.6 per cent) and 2018 (2.0 per cent from 1.9 per cent).
The really big shift in view, with the clearest policy implications going forward, is when the output gap closes — now by year-end instead of the first half of 2018. In fact, in the MPR, the Bank stated that as of Q2, “the degree of excess capacity in the economy was between 0 and 1 per cent.” That is a shocking acknowledgment that the models (but not the markets) show the BoC way behind the curve — using a modified Taylor Rule that incorporates a “lower for longer” zero real neutral rate, the overnight rate should be 1.75 per cent. And in the past, when the gap did close, the real overnight rate was closer to 1 per cent, which therefore puts the nominal overnight rate at 2.75 per cent. That means that the Bank is not stopping at one, or even two more hikes.
This obviously is bullish for the Canadian dollar, especially with U. S. futures not even priced more than 40 per cent for another rate hike by year- end. The Bank has three meetings left, and may well strike at two of these, which would then close the gap with the U. S. and pave the way for a $1.231.25 range on the Canadian dollar, under the proviso that the oil price remains range-bound.
A quick word on this for the trading types. The loonie is way overbought on a technical basis, having gapped nearly five per cent from its 200-day moving average. The last time we saw this condition was on June 9, 2016 — the CAD was $1.2724 per USD that day; a month later it weakened to $1.3044; and two months later, it was sitting at $1.3119. So take some profits right now, but any counter-trend sell-off will likely be a brief affair.
For all the questions about what the BoC rate hike will do to housing and over-leveraged consumers, the real tightening in policy has come via the exchange rate. So the more critical issue is how this is going to affect exports and tourism, which recently had been quite hot. Autos, parts and transports could be dampened most given their FX market sensitivity.
The CAD soared 1.3 per cent the day the BoC moved, which, under the old Monetary Conditions Index which the Bank used to advertise in the 1990s, is equivalent to 43 basis points of tightening! Since the Wilkins speech June 12, which caused the sudden reassessment of Canadian monetary policy, the loonie has appreciated 4.5 per cent — that is a whopper of a 150 basis points in tightening right there, and in barely more than a month!
I found it equally fascinating that even with a 25 basis point hike in the overnight rate, a 7 basis point jump in the 2-year GoC yield, and a 5 basis point increase in the 5- year part of the curve, that the long bond yield (30-year) would actually dip 1 basis point.
The truth is always at the back end of the curve, and it is apparently not buying into this view that the decline in inflation this year was due to a bunch of one- off factors, as the Bank cited in the press statement (autos, electricity in Ontario, food price wars). Imagine what the CAD is going to do to imported auto and food prices going forward too! But our work shows that even excluding these factors, inflation is running at 1.5 per cent, which is still far below the BoC’s target. In fact, when you go to the MPR, what you end up seeing is that the Bank is willing to entertain the notion that a slate of fundamental forces could be at play in the low-inflation backdrop, especially since this has become a global phenomenon, not just here at home.