Interest rate cuts may be more likely than you think, at least in Canada

Posted by: privatefinancetips in BLOG, Manage Money Mar 27, 2016

The Bank of Canada may not be done with interest-rate cuts at this time.

Seven of 19 economists inside a Bloomberg survey predict the central bank will lower borrowing costs at some stage in 2016, with the rest forecasting it will remain on the sidelines. The following decision is March 9.

Although bond financial markets are pricing the chances of more monetary stimulus, the divergence among forecasters highlights a number of uncertainties within the country’s economic story: The currency has depreciated dramatically in the last two years, but it’s unclear when the decline will revive manufacturing. The us government is promising fiscal stimulus, however facts are unavailable before the March 22 budget.

“A rate cut remains on the horizon,” said Thomas Costerg, New York-based senior economist at Standard Chartered Plc, who was the first to call Canada’s slowdown last year. He forecasts the benchmark rate will be cut to 0.25 percent in July, from the current 0.5 percent. “It’s really difficult for Canada’s growth to take off even with a weaker currency.”

Costerg joins economists at the Bank of Montreal, Capital Economics, Macquarie Capital, Citigroup Inc., HSBC Bank Canada and Laurentian Bank in predicting more stimulus from Bank of Canada Governor Stephen Poloz. It’s a view that assumes the impact of the oil shock will persist, and Canada’s non-energy exporters will continue to struggle.

It’s also a view increasingly at odds with bond markets, that are pricing out chances of additional monetary stimulus. Likelihood of an interest rate decline in 2016 fell to around 38 per cent on Friday, from double that in January, according to Bloomberg calculations on overnight index swaps. Poloz quashed rate-cut expectations at his last decision on Jan. 20, partly because he’s waiting to determine details of the government’s fiscal plan.

A return to an easing mode – the financial institution of Canada cut borrowing costs twice this past year – would spell the end of the Canadian dollar’s recent recovery. Since the January rate decision, the dollar has gained 9.2 percent against its U.S. counterpart, making it the top performer among the world’s most- traded currencies. It had fallen 25 % in the two years just before that.

U.S. Spreads

Yields on Canadian two-year bonds have almost doubled since January to 0.53 per cent Friday, narrowing spreads with equivalent-maturity U.S. debt to 35 basis points, from up to 59 basis points. That tightening too is bound to reverse if Poloz cuts again, or does not match any future rate hikes through the U.S. Fed.

Reasons cited for that Bank of Canada to remain around the sidelines include a partial recovery within the price of oil, among the country’s largest exports, and stabilization of global financial markets. The new government under Prime Minister Justin Trudeau is planning certainly one of biggest one-year expansionary swings in fiscal policy within the nation’s history, hinting at deficits of approximately $30 billion this year. There’s also a growing sense in global policy making circles that central bank effectiveness is reaching its limit.

None of this is persuading skeptics like Costerg and Doug Porter at Bank of Montreal. For one, the recent gains within the dollar ought to be a new concern for Poloz because of the need for export growth in his rebound story. The central bank governor in January cited the risks in the rapid depreciation of the currency as among the causes of not cutting rates of interest at the time.

“The reality is the currency isn’t any break on the Bank of Canada anymore,” said Porter, chief economist at BMO Capital Markets, which is alone among the country’s top 5 banks forecasting a cut this year.

Investment within the nation’s oil industry will still be a drag on growth, even when prices recover, said Costerg, who first cut his forecasts for the Canadian economy in January 2015, six months before the majority of his peers adjusted, on the back of worries about the Canadian crude sector. He’s been pessimistic about Canada’s prospects since.

‘Did Math’

“We simply did the math,” Costerg said of his forecasts last year. “We had the view the stop by oil prices would be a big shock towards the economy given the size the energy sector.”

David Doyle at Macquarie Capital, which predicts the Canadian dollar will fall to a record low of 59 U.S. cents the coming year, cites three logic behind why he thinks the Bank of Canada is simply too optimistic and will likely cut rates: exports probably won’t recover as robustly as expected, rising import inflation will eat into consumer budgets and government expenses are unlikely to have the hoped-for impact, partly on delays getting money out the door.

“We continue to believe that the financial institution of Canada and consensus growth forecasts for the domestic economy are extremely optimistic,” Doyle said inside a phone interview. “We believe many people have become more constructive on the outlook with different couple of things which there isn’t much evidence occurring yet, the very first as being a get in export activity.”

Other areas of concern include stretched home valuations and worries the oil shock could spill over into consumption, a place of strength for Canada. There’s also doubts about the country’s capability to benefit from a weaker dollar. The close correlation between your currency and manufacturing doesn’t appear to mean as much as it has previously, possibly suggesting deeper issues for the Canadian economy with the emergence of stiffer competition from countries like Mexico.

David Watt, chief economist at HSBC Bank Canada, believes it’s too early to stop on monetary policy. “An excessive amount of has been placed on fiscal policy,” said Toronto-based Watt. “We still need a mixture of fiscal and monetary.”

Bloomberg News