Yesterday’s Bank of Canada meeting poses the greatest short-term risk to our outlook.
Governor Stephen Poloz is currently in a precarious position; cut by 50 basis points and risk inflating house prices further or cut by 25 basis points and run the risk of currency appreciation unwinding the stimulus.
Swap markets, which have been the best predictors of central bank policy since last week, are tilting towards the first option.
At time of writing, a 43 basis point cut is baked into the Overnight Index Swap curve for Canada, implying a 71% probability of a 50 basis point cut.
The bank will undoubtedly ease policy, which runs against our view that the threshold to further easing is high due to fears of spurring a housing bubble and would leave the BoC only verbally intervening, but predicting the depth of such a cut is not a clear cut decision.
Below are some of the potential scenarios that could take place:
- Governor Poloz matches the Federal Reserve’s decision and cuts by 50 basis points. Economic activity was already weak in Q4 and showed signs of spilling over into Q1 even before the coronavirus took hold. This prompted a dovish stance by the Governing Council in the January meeting. Poloz will be more than aware that not cutting rates by a similar magnitude to that of the Fed it runs the risk of sharp currency appreciation, which could in turn mitigate the stimulus measure of a rate cut itself. The BoC has previously shown little appetite for a strong currency in an environment of low growth. Markets saw this feedback loop at the back-end of 2019 during the height of the trade war – if the loonie strengthened too much below the $1.3150 barrier it embolden policy members to strike dovish tones. With oil prices also sitting at low levels, which tainted investment and growth in parts of Q4 2018 and Q1 2019, and the output gap already set widen in 2020, the risk of such a large cut to inflation are reduced. The only drawback to such a stance is provoking the housing market. With one of the highest household debt-to-GDP levels in the developed space, the level of household leverage remains a primary concern for the BoC. Recently, regulation around mortgages has loosened to allow for the rise in house prices allowing individuals to take out mortgages with a higher percentage to their income. If coupled with lower interest rates, a housing bubble could quickly materialise. The risk of creating financial risks lead to Poloz refraining from matching the Fed’s move yesterday. However, it must be noted this is the likeliest option as the BoC currently has the most space to cut rates within the G10.
- A 25 basis point cut has its merits and runs in line with the BoC’s recent policies of data dependence and patience, but runs the risk of widening yield spreads and unwelcome loonie strength. Such a move has been witnessed with EURUSD over the last few days – as the unwinding of carry trades wore off and speculation of Fed cuts heightened, US yields fell dramatically faster than those in the eurozone, thus prompting euro strength. So far the impact of the coronavirus has been felt in Canadian trade data due to weakened external demand. Now the virus threatens more domestic factors, the BoC will be more than aware that a 25bps cut would reduce how competitive Canadian exports are. Front-end US-Canadian yield spreads are already at levels not seen since early 2015.
- One potential escape route could be a 25 basis point cut with a strong signal that another 25 basis point cut is set to come in April’s meeting when the Monetary Policy Report is due. The bank has rarely altered rates without the accompanying MPR, which outlines fresh forecasts on the state of the economy, but these are not normal times. The loonie will likely strengthen on such an announcement and could be embarrassing for the Bank of Canada should the impact to the economy warrant a more aggressive stance later down the line.
Oil markets and the OPEC+ response
Additional risks to the outlook come from the response by OPEC + to the current macro climate.
Russia previously rejected suggestions by Saudi Arabia to deepen the current output quota agreement and extend the length of the arrangement, however, recent reports suggest Russia is more open to scaling back crude production as oil fell far below the $50 mark.
Officials are set to meet in Vienna for a 2-day meeting. Preliminary estimates of cuts range from 600,000 bpd – 1m bpd along with an extension of the current quota limits into 2021, but the likely outcome is unknown.
Support for oil markets from both global stimulus measures and supply cuts could help cap any decline in the Canadian dollar below the $1.35 level.
Graph: US-Canada 2-year yield spread touched its lowest point since 2015 before the Fed cut rates yesterday
Author: Simon Harvey, FX Market Analyst at Monex Europe.