A Cause for Pause

The Bank of Canada continues to emphasize its data dependency approach to guide future policy decisions. But we think there are two developing stories that might make this data dependency more fragile through the rest of the year, and therefore more likely to pause even if the data come in as strongly as expected.

The Bank of Canada (the Bank) raised the target overnight rate at its July meeting for the fourth time in a year and reemphasized its data dependency approach to guide its future policy decisions. By the Bank’s reading of the data, things are chugging along nicely: the July Monetary Policy Report highlighted a Canadian economy operating close to full capacity and GDP growing faster than potential.

That bullishness over data has markets anticipating at least one more rate hike this year. However, we are maintaining our expectation that the Bank will take a rate-hike hiatus for the rest of the year, driven by two developing stories:’

  1. The first is trade. To the extent that trade-related tensions heat up, both between Canada and the U.S. and between the U.S. and the rest of the world, the U.S. is more likely to act on its protectionist rhetoric. The resulting uncertainty should be a force to deter the Bank from moving ahead.
  2. The second developing story is the shape of the yield curve. Governor Poloz has ascribed its flattening to demand on the long end from pension funds and insurers, and therefore as somethingthat can be safely ignored. It might also be driven by demand for long-duration fixed income as markets are looking for insurance against Minsky moments like the ones that occurred in 2000 and 2008, ahead of which the yield curve flattened and then inverted.

More to the point, the underlying reasons might not matter that much. Ignoring the flattening curve raises the risk of its inverting, and that would likely have real economic ramifications. In particular, credit creation should slow down considerably, generating a negative feedback loop throughout the economy.

Our view is that if these risks develop, the Bank will be more or less forced to consider a risk management approach for its policy decisions and it will therefore be more inclined to stand pat. In short, the data will have to be exceptionally strong to motivate the Bank to raise rates again this year.

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