Wednesday, January 21, 2015

Bank of Canada's Turn to Shock Markets?

Barrie McKenna of the Globe and Mail reports, Bank of Canada shocks market with rate cut:
The Bank of Canada announced a surprise quarter-percentage-point cut to its key interest rate Wednesday – a move it calls “insurance” against the potentially destructive effects of the oil price collapse.

The reduction in the bank’s overnight rate to 0.75 per cent from 1 per cent – its first move since September, 2010 – comes as a precipitous drop in the price of crude slams Canada’s oil-dependent economy.

The oil shock will be “negative for growth and underlying inflation in Canada,” the bank warned in a statement.

Bank of Canada Governor Stephen Poloz is expected to explain his dramatic decision at an 11.15 a.m. news conference in Ottawa Wednesday.

The rate move, which few analysts anticipated, is an attempt by Mr. Poloz to shield highly indebted Canadian households from an oil-induced hit to their jobs and incomes – signs of which are already evident in Alberta.

The rate cut is a signal to private-sector banks to lower their own rates on mortgages and other loans.

It’s also likely to accelerate a slide in the Canadian dollar, now at roughly 83 cents (U.S.).

Cheaper crude, while good for the U.S. and global economies, is unequivocally bad for Canada.

The bank warned that lower oil prices would take a sizeable bite out of economic growth in 2015, delay a return to full capacity and hurt business investment – a trend that has already triggered mass layoffs and production cuts in Alberta’s oil patch.

But the effects could spread further, threatening financial stability as a result of possible losses to jobs and incomes, according to the central bank.

“The oil price shock increases both downside risks to the inflation profile and financial stability risks,” the bank acknowledged. “The Bank’s policy action is intended to provide insurance against these risks.”

The bank’s new forecast assumes a price of “around” $60 per barrel for Brent crude, more $10 above where it is now. But the central bank said prices “over the medium term are likely to be higher” than $60.

As recently as June, oil was selling for $110 a barrel.

The bank also lowered its bank rate and the deposit rate by a quarter percentage point Wednesday, to 1 per cent and ½ per cent, respectively. And it removed any indication of which way rates might go next.

The bank’s decision coincides with a much more pessimistic economic forecast than the bank issued just three months ago.

Following the lead of most private-sector forecasters, the bank slashed its GDP growth forecast to 2.1 per cent this year (from 2.4 per cent), before rebounding to 2.4 per cent in 2016. The worst effects of the oil collapse will be felt in the first half of this year, when the bank expects annualized growth of 1.5 per cent, nearly a full percentage point lower than its October forecast.

The Canadian economy grew at an estimated rate of 2.4 per cent in 2014.

The bank said the economy won’t return to full capacity until the end of 2016, several months later than its previous estimate of the second half of next year. Among other things, the central bank pointed to significant “labour market slack.”

Crude’s effects on the economy will be broad and profound, the bank warned. Investment in the oil and gas sector will decline by as much as 30 per cent this year, while lower returns on energy exports will eat into Canadian incomes, wealth and household spending.

The bank also hinted at a possible spread to other parts of the country of a real estate slump already underway in Alberta. “The extent to which the downturn already evident in Alberta will spill over into other regions remains to be seen,” the bank pointed out in its monetary policy report.

“The ramifications of the oil-price shock for household imbalances will depend importantly on the impact of the shock on income and employment,” the bank added.

The bank also expressed growing angst about the impact that oil could have on inflation, which it said has been propped up by temporary effects, such as the “pass-through” effect of the lower Canadian dollar.

Consumer price increases, now running at roughly 2 per cent a year, are “starting to reflect the fall in oil prices,” the bank said.

The bank’s new forecast calls for overall inflation to fall well below its 2-per-cent target this year, averaging just 0.6 per cent. Core inflation, which strips out volatile food and energy prices, is expected to average 1.9 per cent in 2015.
You can read January's Monetary Policy Report for more details as to why the Bank of Canada decided to cut its overnight rate, but one thing is for sure, it caught a few folks off-guard.

Pamela Heaven of the National Post recently reported, Don’t expect a rate hike before 2016, Canada, because 2015 already seriously sucks:
The sour start to the new year is prompting more economists to push back their forecasts for a Bank of Canada rate hike and lower their forecasts for growth and the Canadian dollar.

Plunging oil prices, down more than 50% since June, have been joined by record low yields for 10-year Canadian bonds, a six-year low for the loonie and declines in a host of other commodities.

“It’s not unusual to have a lot of bad news packed early into January, because the post-holiday period often ushers in some changes in strategy — but this year has already seen more than its fair share of very tough decisions,” said BMO chief economist Doug Porter in a recent report.

The bad news prompted economists at BMO Capital Markets to push their call for the next rate hike into 2016 — even though the Fed is still expected to hike three times this year.
The bank also reduced its outlook for the Canadian dollar, which has already fallen below their previous 2015 forecasts, and now sees it testing 80 cents US by mid-year.

“Finally, we are also taking another long look at trimming our below-consensus GDP forecast of 2.1% this year, which is already a full percentage point below our U.S. call of 3.1%, and would represent a highly unusual underperformance by Canada,” said Mr. Porter.

BMO joins a growing chorus of economists who now see the Bank of Canada remaining in interest-rate hibernation for at least another year.

A rate hike in 2016 is now the median forecast in Bloomberg’s monthly survey, which previously predicted the Bank would lift rates later this year. Economists also cut two-year yield forecasts by the most on record. Some forecasters don’t see a rate hike until 2017.

Bets are also increasing that Bank of Canada Governor Stephen Poloz will cut rates, rather than raise them, with swaps trading signalling about a one in three chance of a reduction to 0.75% by December.

The central bank hasn’t raised its benchmark interest rate since 2010 — the longest pause since the Second World War — as it awaits an economic recovery, but instead of getting closer that goal seems further away.

Wednesday, the Bank of Canada will update its growth expectations, along with its monetary policy decision, and nobody expects it to be good. October’s forecast was based on oil prices at US$85. It was trading at $46 Tuesday.

“They are definitely going to have to acknowledge that there is a large downside risk from falling oil prices,” in the new economic forecast, Emanuella Enenajor, senior Canada economist at Bank of America Corp. told Bloomberg. Last week she pushed her rate-increase forecast to the third quarter of 2016 from the first quarter.

If that’s not enough, January has brought an extra heavy dose of bad news: Here are the highlights, according to BMO:

Target exits Canada: The troubled American retailer stunned Canadians when it announced last week it will close all 133 stores at a loss of 17,600 jobs after less than two years in the country. Mr. Porter says the move, however, says more about the retailer than it does about Canada’s economy where retail sales have kept pace with the U.S.

Suncor cuts 1,000 jobs and capital spending: Capex cuts have become common in the oil patch, but jobs cuts by Canada’s largest oil company is a darker omen that doesn’t auger well for Alberta’s economy. “We look for growth in the province to drop to around 0.5% this year after leading the country with 3.5% growth in 2014, and that’s based on a partial recovery in oil in the second half of the year. The housing markets in Calgary and Edmonton look to be softening notably, with the high possibility of outright price declines in both cities this year. The oil plunge has skewered provincial finances, leaving Premier Prentice to openly talk about the possibility of introducing a provincial sales tax to help stabilize revenues—now, that would be a tough decision,” wrote BMO.

Finance Minister Oliver delays the federal budget: Ottawa is suddenly sounding more cautious about lower oil prices. BMO’s analysis sees the government needing “to use its full $3 billion contingency reserve to balance the books in the coming fiscal year, leaving zero room for any new measures in this year’s budget.”

The Swiss National Bank releases the cap on the franc: The move shocked markets and sent the franc soaring 30%. This is important to Canada because such a huge move in a major currency creates unintended shockwaves which only become obvious in days to come, writes Mr. Porter. The move pushed global yields down and gold up, “the one commodity that is thriving in today’s uncertain backdrop.”

Update: Tuesday the loonie sunk almost a penny below $83 cents US after Canadian factory fell 1.4%, the third drop in four months — and way below economists’ expectations.
But not everyone was caught off-guard. Bloomberg reported that Canada’s dollar weakened to the lowest in more than five years on speculation the central bank may signal it’s more likely to lower interest rates than raise them when it releases a growth outlook.

Other economists thought Bank of Canada Governor Stephen Poloz can hit rate snooze as markets do the work:
Poloz, who delivers the central bank's next rate decision on Wednesday, will hold off raising borrowing costs until 2016, according to the median forecast in a Bloomberg monthly survey, which previously predicted the governor would lift rates later this year. Economists also cut two-year yield forecasts by the most on record.

The central bank hasn't raised its benchmark interest rate since 2010 as it awaits an economic recovery that's in danger of fading. Crude oil, Canada's biggest export, is trading below $50 a barrel, from $107 in the summer. The slump is already crimping exports, weakening investment and playing havoc with prairie housing markets. The last thing the economy needs is higher interest rates.

"Markets are doing the dirty work for the Bank of Canada," Emanuella Enenajor, senior Canada economist at Bank of America, said Jan. 15 by phone from New York. "We are still going to see the Bank of Canada holding on to their assertion that the recovery is proceeding, perhaps it's just proceeding a bit slower than they thought."

Along with the rate decision, Poloz will release the bank's quarterly set of inflation and growth projections that will be updated to factor in cheaper crude oil. The bank's October forecasts were underpinned by an assumption U.S. benchmark crude would trade at an average of $85 a barrel.

The oil slump means it may take longer than expected to return the world's 11th-largest economy to full potential, Deputy Governor Tim Lane said in a Jan. 13 speech. He reiterated Poloz's December estimate that weaker oil may shave a third of a percentage point off 2015 growth. Oil extraction accounts for about 3 percent of Canada's gross domestic product and crude oil about 14 percent of exports, Lane said.

"They are definitely going to have to acknowledge that there is a large downside risk from falling oil prices," in the new economic forecast, Enenajor said. Last week she pushed her rate-increase forecast to the third quarter of 2016 from the first quarter.

The yield on Canadian government bonds due in two years will end 2015 at 1.45 percent, according to the Bloomberg survey's median forecast, down from a December projection of 1.8 percent.

Economists also cut forecasts for the 30-year yield, to 2.96 percent from 3.38 percent last month.

"Investors are willing to receive no increase in purchasing power for three decades," Sal Guatieri, a senior economist at BMO Capital Markets in Toronto, wrote in a Jan. 16 research note. "How bad of a mess do investors think the global economy is in?"

The Bank of Canada has kept its benchmark rate at 1 percent since September 2010, predating Poloz taking the governor job, and is the longest stretch since World War II.

Bets are increasing that Poloz will cut rates, rather than raise them, with swaps trading signaling about a one in three chance of a reduction to 0.75 percent by December.

International investors are adding to their Canada bond holdings even in a low-rate world, while selling stocks for the first time in 15 months, a Statistics Canada report Monday showed. Foreigners bought C$4.75 billion of bonds in November while divesting C$580 million of stocks.

The Bank of Canada's Lane cautioned in his speech against too much pessimism, noting policy makers won't react to the temporary drop in inflation triggered by oil's plunge. He also pointed out the offsets including the benefits to consumers from cheaper prices at the pump, and the advantage some exporters will gain from a weaker currency, he said.

"We will continue to work to bring the Canadian economy back to its potential and return inflation sustainably to our 2 percent target," Lane said. "However things play out, we have the tools to respond."

Tell that to Calgary property owners. Homes sales in the nation's oil hub and Alberta's largest city plummeted 24.6 percent in December from the previous month, the Canadian Real Estate Association said last week. That was the worst drop since the 2008 bankruptcy of Lehman Brothers Holdings Inc. sparked the global credit crunch.
Indeed, Calgary's real estate market is cooked, and nobody knows this better than Garth Turner whose blog, The Greater Fool, has gained quite a following as over-indebted Canadians are increasingly worried about the value of their home.

But Garth Turner and I differ quite a bit on what will rock Canada's residential real estate market. He buys the Wall Street fairy tale that the U.S. economy is doing so well that the Fed will raise rates later this year, forcing the Bank of Canada to raise rates which will spell the end of Canada's long real estate boom. I think rates are heading lower as global deflation picks up steam and unemployment will soar in Canada, and this will be the death knell for our real estate market.

On Friday, I wrote a comment on why OMERS is worried about deflation, where I explained in detail why I'm betting the Fed won't raise rates this year and might even be forced to engage in more aggressive QE if a financial crisis emerges.

And let me tell you, Steve Poloz isn't stupid. Far from it, he's one of the smartest and nicest guys I've ever had the pleasure of working with and understands extremely well why the Fed is backed in a corner and increasingly worried about deflation coming to America.

This is one reason why I agree with Ted Carmichael who recently wrote the Bank of Canada should open the door to a rate cut now where he noted the following:
I believe that, in this debate, David Wolf's view is more likely to prove accurate. While I am in broad agreement with his assessment, in my opinion, he fails to mention one important link in the virtuous cycle that has turned vicious. When the price of oil [and other commodities] falls, Canada's terms of trade (ToT) weakens. When the price of commodities falls relative to the price of other goods and services, the price of Canada's exports falls relative to the price of its imports.


When the commodity terms of trade weaken, Canada's gross domestic income weakens. This negative shock to income is shared across the corporate sector, the government sector and the household sector. While some energy consuming industries will benefit, total corporate profits will fall. Government revenues will fall, causing most governments to curtail discretionary spending.
While commuters will benefit from lower gasoline prices, the lower Canadian dollar will make imports of finished consumer goods and services more expensive. As housing and other asset prices weaken against a backdrop of record high household debt-to-income ratios, consumers will be reluctant to spend any windfall bestowed by lower energy prices. Many will prefer to save rather than spend the temporary boost to disposable income.

What is noteworthy about the chart above is that the depreciation of the Canadian dollar, significant as it has been, has not kept pace with the deterioration of the commodity terms of trade. Even if oil and other commodity prices stabilize at current levels, the Canadian dollar needs to fall further, to below 80 US cents (or alternatively USDCAD needs to rise above 1.25), to have a chance to offset the negative impact of the terms of trade deterioration on growth and inflation.

The Bank of Canada will make a policy rate decision and release an updated projection for the Canadian economy on January 21. The biggest change will be in the inflation projection. The table below shows the Bank of Canada's Total CPI inflation projection made in its October Monetary Policy Report (MPR) and JP Morgan's latest Canadian inflation forecast which incorporates most of the recent decline in crude oil prices.


The JP Morgan forecast anticipates that CPI inflation will turn negative in 2Q15 (as I predicted here) before edging back toward 1% by 4Q15 assuming that the price of oil rebounds toward $90 per barrel by the end of 2015. If, as I believe likely, crude oil prices remain depressed for a much longer period of time, say well into 2016 or 2017, inflation will likely fall into negative territory in early 2015 and remain there for some time.

With such an outlook, the Bank of Canada needs to pay full attention to defending its inflation target and supporting inflation expectations around 2%. The most effective way to do this in the near term is to provide guidance in the January 21 policy rate announcement and the Monetary Policy Report that the BoC stands ready to cut the policy rate if inflation moves persistently below the 1-3% target band.
I completely agree with Carmichael's excellent analysis. In fact, I would have urged the Bank of Canada to really shock markets and cut rates by more than 50 basis points even if it would have sent the loonie plunging to new lows (I see the loonie falling back below 70 cents US in less than a year).

Why am I so pessimistic on Canada? Because we live in a bubble here. Most Canadians have been lulled into believing our economy is invincible and can weather any global storm because of our proximity to the U.S. and our resources which up until recently were being snapped up like crazy by China and other emerging markets.

Unfortunately, Canada's crisis is just beginning, and there will be considerably more pain ahead. Never mind what those smart economists from Canada's big banks tell you, listen to Leo Kolivakis and Leo de Bever who warned all of you in December 2013, long before oil prices plunged, that it's time to short Canada.

I don't know, maybe I'm being too cynical and too pessimistic. My friend Brian Romanchuk wrote an excellent comment on why Canada is still debalancing, noting the following:
The rather rapid depreciation of the Canadian dollar should allow for rebalancing within the economy. In addition to exporters becoming more competitive, imports are more expensive and so there may be substitution away from foreign suppliers. Based on past experience, the impact on Canadian consumer price inflation will be muted; exchange rate moves are typically absorbed within profit margins. Additionally, the fall of gasoline prices benefits consumers across the country, although this will not buoy spirits in Calgary.

The question is: can Canada avoid the messy unwinding of its housing bubble that was experience in other countries? Differences in how mortgages are financed means that the banking system should avoid a crisis. However, the real risk is in the labour market. Construction job losses will have a multiplier effect, dragging down demand-sensitive sectors like Retail. Finally, health spending is under the control of Provinces, which have much larger economic footprints than American States, but do not have direct access to the central bank. The Canadian financial press worships at the altar of fiscal rectitude, and a pro-cyclical fiscal tightening is highly possible.

At present, all one can safely say is that the downward spiral has not yet started.

Policy Response

Unless the economy makes a very dramatic downturn, there is little reason to expect policy changes over the coming year.

The Bank of Canada is unlikely to move rates in either direction in 2015. If the Fed hikes rates, the Bank of would only follow with a lag. This would put the earliest rate hike in 2016, and we will have another year's worth economic data to digest. Going the other way, there is almost no scope to cut rates. A token cut of 50 basis points is possible, but the Bank of Canada has found that zero rates is not compatible with a proper functioning of the Canadian money markets.

Fiscal policy is unlikely to be helpful, although the Federal Government may decide to loosen the purse strings ahead of an election. (Although the Conservative Party positions itself as fiscally conservative, they were certainly Keynesian during the financial crisis.) Analysts are now giving up on forecasts of a Federal fiscal surplus, which is what I said would happen last year in "Canada: Enjoy The Projected Surpluses While They Last". The real risk is that Provincial governments will be forced to tighten policy, but that would not happen until after there is a visible downturn and their deficits blow out.
In a follow-up comment, Brian questioned the decision to cut rates, calling it a policy error:
The Bank of Canada surprised markets (and me) and cut the overnight rate to 0.75% from 1% today. Even though I have been saying that the Canadian economy is doomed for a long time, I think this was a policy error. Interest rates 25 basis points lower will have no measurable effect upon the economy, but it will most likely be interpreted as the beginning of a (very short) rate cut cycle. Since rate cut cycles are almost invariably associated with recessions, the correct question to ask: what does the Bank know? The biggest risk facing the economy is a loss of confidence in the ability of Canadian households to service their debts; increasing uncertainty is the last thing Canada needs. The weaker Canadian dollar will take quarters or even years to help growth (as a result of the J-curve), but confidence within the housing market could be lost within weeks.
Obviously the Bank of Canada is more worried about the Canadian economy than most and I believe justifiably so. Pay attention here folks, Canada's crisis is just beginning, and that's the real reason Canada's large public pension funds are snapping up Canadian government bonds, even at record low yields.

Below, Stephen S. Poloz, the Governor of the Bank of Canada, speaks before the Economic Club of New York on Speculating on the Future of Finance. Listen carefully to Steve, he's a very sharp guy and we're lucky to have him at the helm of our central bank during these turbulent times.

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