Remember when Bank of Canada governor Stephen Poloz, emphasizing downside risks to the economy, declared that Canadian monetary policy would remain in neutral? That was only two months ago, but apparently a lot has changed.
In mid-June, Bank officials began signaling that extraordinary stimulus, implemented in 2015 through two interest rate cuts, may no longer be needed. Then, in mid-July, it followed up by raising the target overnight rate by 25 basis points – the first interest rate increase in seven years. Bank officials are couching the removal of accommodation as a mere unwind of the emergency cuts it made to address the energy price collapse of late 2014. Yet the new direction raises more than a few questions for investors.
What drove the shift?
GDP growth, job growth and retail sales have been strong lately, and according to the Bank of Canada’s Business Outlook Survey, corporations are growing more positive about their capital spending intentions. Housing risks have been mounting, inflation remains subdued and any rotation toward non-energy export growth is unclear, but the Bank seems firm in its belief the recovery is broadening out across regions and sectors.
How far can hikes go when inflation sits well below target?
To our mind, the best argument against raising rates is soft inflation data. In May, the Bank’s three preferred measures of core inflation fell from their 2016 levels and are well below target. Yet the Bank has downplayed the trend, citing special factors (like retail food competition) and past economic slack; in any event, it argues, inflation responds to monetary policy with considerable lag. We expect more forceful language from the Bank about being pre-emptive – and indeed Poloz has recently talked up a focus on indicators that “predict inflation.” Central banks have largely eschewed pre-emptive actions during this cycle, but the Bank of Canada’s new tone is coinciding with hawkish signals from other developed country policymakers, such as the Bank of England and the U.S. Federal Reserve. That gives the impression of a coordinated move.
What about trade and housing risks?
One of the best arguments for caution has been the risk of higher U.S. tariffs in the form of a border adjustment tax or renegotiation of NAFTA; those concerns, however, seem to have subsided somewhat. Housing risks are more complicated. Tentative evidence suggests that macro-prudential policies introduced recently in British Columbia and Ontario have slowed activity. The Bank, however, seems perhaps willing to look past a significant house price correction in Toronto, Vancouver and surrounding areas; it would be more concerned by a spillover into a broad-based downturn. We expect the Bank to watch housing market vulnerabilities closely, but it currently appears that it does not consider them a barrier to action.
The big question: What next?
Until recently, we were confident that the Bank would remain on hold throughout 2017. No longer. We now expect it to hike at least once more this year, likely October, as it seems determined to remove at least the 50 basis points of cuts it made in 2015. For investors, the biggest risk is a messy unwind of positions as rates push higher. A response worth considering would be to shorten fixed-income portfolio duration and position for steeper yield curves down the road. With the Bank of Canada turning hawkish, it’s time to consider being very defensive.
Aubrey Basdeo is a Managing Director and Head of Canadian Fixed Income for BlackRock. He is a regular contributor to The Blog in Canada.