The Bank of Canada left its key overnight interest rate unchanged in its April 15 announcement – no surprise there. Given that the central bank had been signalling for some time that it was taking time to assess the impact of the “insurance” it took out in January with a surprise 25 bps rate cut, most analysts expected Governor Stephen Poloz to stand pat. And he did. Now, with that out of the way, the more important factor is what the Bank sees as the trajectory of economic growth for Canada, because that will be fixed income investors’ guide for how it will react to disappointment or surprises along the way. For the record, we believe there is a lot of room for disappointments that may derail the Bank’s forecast growth trajectory.
But first let’s look at what the Bank had to say about the economic picture going forward. The storyline goes something like this: Yes, the first quarter was terrible, maybe even atrocious, but things are going to get better real fast. In its quarterly Monetary Policy Report, also released today, the Bank revised its Q1 growth forecast down to zero (it might even go lower), but revised up its number for Q2. The central bank now expects growth GDP to grow by 1.8% in the second quarter, compared with its previous estimate of 1.5% growth. The picture gets even rosier from there: estimates for Q3 growth have risen to 2.8% from 2%, and fourth-quarter growth is pegged to come in at 2.5%. So we’re seeing estimates of a very strong rebound in the second and third quarters of 2015.
The implication is that when it comes to providing monetary stimulus, the Bank has done enough to get things moving once the economy has shed its winter doldrums. The currency is devalued, and that should spark growth in export-oriented sectors with a high sensitivity to the Canadian dollar, like manufacturing. Oil prices are stabilizing, if not increasing, neutralizing further fallout from the oil shock. Meanwhile, growth in the United States looks robust, which should increase demand for Canadian stuff. The world, in other words, is unfolding as it should, and it will take a big surprise to get the Bank of Canada to change its mind on rates.
So the trajectory now seems set (at least until the next MPR in July), and fixed income investors will be watching the data closely to see their impact on that trajectory. At the moment, however, the certainty of a strong rebound in the second quarter is very much open to question.
After all, where is this growth likely to come from? Oil prices might have stabilized, but it is very hard to imagine a rebound to US$90 any time soon, given the continuing glut on the supply side. The Canadian consumer, meanwhile, might be benefiting from somewhat cheaper gasoline, but their spending capacity is stretched thanks to a record high level of household debt. The housing market still looks strong (with some regional exceptions, like Alberta), but you have to question how much further home valuations can rise given all that debt. That leaves, for better or worse, manufacturing. And we believe that the outlook is probably for the worse, or at least not as good as the Bank is hoping for. The merchandise trade numbers, also released on April 15, were disastrous. Manufacturing sales fell by 3% in January and by a further 1.7% in February, even while U.S. auto sales have been fairly robust.
Now, there is no doubt that the currency’s decline is good for manufacturing, but given that the loonie has depreciated by 30% since 2011, we would expect to see better growth. And yet manufacturing has remained very weak, which suggests that other things besides currency is at play here.
One of them is globalization. America might be Canada’s largest export market, but there is nothing special about that: China, Europe, South America and Mexico (where Toyota is relocating its Corolla plant from Ontario) are all chasing the same market. Meanwhile, our unit labour costs are relatively high, and Canada’s manufacturing capacity is stretched because so many plants and jobs disappeared during the era of the soaring loonie. It will take time for manufacturing to rebound, even with a weakened currency, and it will probably never return to the levels it did 10 or 20 years ago. This is not a three-month repair job. And it means that whatever benefit Canada realizes from a strong U.S. economy will be more muted than before.
Given all those factors, the likelihood is high that the trajectory of economic growth will be lower than the Bank of Canada is currently expecting. We think the Bank will take out more insurance later this year in the form of two more rate cuts.
Aubrey Basdeo is a Managing Director and Head of Canadian Fixed Income for BlackRock. He is a regular contributor to The Blog and you can find more of his posts here.
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