Bank of Canada Preview

Bank of Canada meets next week. Data have been coming in soft, but it seems too soon to expect a rate cut. Markets are pricing in steady rates this year but may have to adjust expectations if the economy continues to weaken.

RECENT DEVELOPMENTS

Canadian data have been running weak in Q4. This kicked off with November jobs data, which showed a -71.2k drop in total employment. Next up was October retail sales, which fell -1.2% m/m vs. +0.5% expected. GDP growth slowed to 1.2% y/y that month, the slowest since February. December Ivey PMI plunged to 51.9 from 60.0 n November, while housing sector data softened considerably. The only bright spot has been December jobs data, where a 35.2k rise in total employment partially reversed the November reading. It’s unclear whether this improvement can be sustained.

Bank of Canada Governor Poloz has tilted more dovish recently. In a speech last week, he warned that damage to the global economy from global trade tensions will likely be permanent. Poloz added that “plenty of uncertainty remains around the implications of the U.S.-China agreement for Canadian exports and around whether any more of the new tariffs can be rolled back.” He also noted that job growth has slowed in recent months but was offset by a pickup in wages, adding that “We will be watching the data carefully to see how much of the recent moderation persists.”

Poloz’ 7-year term ends in June and he indicated last month that he will step down rather than seek another term. A search for his replacement has begun. Senior Deputy Governor Carolyn Wilkins is seen by many as the frontrunner. Other possible candidates are former Senior Deputy Governor Tiff Macklem, Deputy Finance Minister Paul Rochon, former Deputy Governor Jean Boivin, and current Deputy Governor Paul Beaudry.

Justin Trudeau and his Liberal Party won the most seats in the October 21 election. However, with its 157 seats falling short of a majority in the 338-seat Parliament, the Liberals are ruling as a minority government. As a minority government, it must get support from other parties on a case by case basis, which raises the risk of policy paralysis at times. Interestingly, the Liberals won only 33.1% of the popular vote vs. 34.4% for the Conservatives, but Canada’s first-past-the-post system led to a greater number of seats won.

Reports suggest Finance Minister Bill Morneau will focus on climate change in his budget plan that will likely be unveiled in February or March. Policies will reportedly be aimed at reducing energy consumption and allocating funds to address the impact of fires and flooding. Last year, the Liberal government introduced a national carbon tax. The Bank of Canada’s quarterly business-outlook survey showed that a majority of businesses see the impact of climate change is “a relevant or very relevant topic” for running their operations, citing financial losses from extreme weather and increased climate-related costs.

The US Senate just passed the USMCA trade deal by a vote of 89-10. The House passed it last month by a vote of 385-41, as has Mexico’s Senate. This leaves only Canada, and officials say that the government will move forward with ratification after Parliament reconvenes later this month. While it is expected to pass, the process may be slowed as the Liberals will likely have to make concessions to get other parties to support USMCA. Stay tuned.

 

A BRIEF HISTORY LESSON

The Bank of Canada is relatively young. It was only chartered in 1934 by the Bank of Canada Act. One year later, it opened its doors at its new headquarters in Ottawa. The bank was initially privately held but the Act was amended to nationalize it. Indeed, that Act has been amended many times since 1934 but the preamble remains the same, which says that the Bank of Canada exists “to regulate credit and currency in the best interests of the economic life of the nation.”

The Bank of Canada is led by the Governing Council. This is made up of the Governor, Senior Deputy Governor, and four Deputy Governors. Interestingly, the Council makes its policy decisions by consensus rather than by tallying up individual votes. The Governor and Senior Deputy Governor as appointed by the central bank’s Board of Directors, subject to approval by the Cabinet led by the Prime Minister and Finance Minister. Otherwise, the federal government has no role in choosing. The Deputy Finance Minister sits on the Board of Directors but has no vote.

Inflation targeting was adopted in 1991. The Council sets policy in order to meet the inflation target of 2% +/- 1 percentage point. That target has been renewed numerous times, the latest being in October 2016. The policy rate is set to achieve that target within a horizon of 6-8 quarters, which it widely believes to be the time it takes for monetary policy to impact the economy.

 

ECONOMIC OUTLOOK

The economy is slowing. The OECD sees 2019 growth at 1.5%, picking up modestly to 1.6% in 2020 and 1.7% in 2021. GDP rose 1.7% y/y in Q2. However, monthly data so far in Q4 suggest some further deceleration and Bloomberg consensus sees 0.9% y/y. If so, that would be the slowest rate since Q2 2016. As such, we see some downside risks to these growth forecasts.

Price pressures remain low. Headline inflation picked up to 2.2% y/y in November after coming in at 1.9% the previous three months. Inflation remains near the 2% target and is likely to remain there for the most part in 2020. December data will be reported hours before the BOC decision next Wednesday. Elsewhere, common core CPI inflation has been stuck at 1.9% y/y the last three months up to November.

Bank of Canada started a tightening cycle back in July 2017 with a 25 bp hike to 0.50%. It hiked four more times since then to 1.75%, the last moving coming in October 2018. Its language has tilted more dovish in recent months, supporting our view that it may eventually join the ranks of those cutting rates. For now, however, we expect the bank to deliver another dovish hold. WIRP suggests zero odds of a cut at the January 22 meeting, rising to 10% for both March 4 and April 15. However, the odds really don’t rise much beyond this as we move into H2. We await further clarity from the data, and much will depend on the global backdrop and oil prices.

The fiscal accounts remain solid. The OECD sees the budget deficit falling to -0.5% of GDP in 2020 and -0.3% in 2021 from -0.6% in 2019. This trajectory will also depend on the global growth outlook and oil prices, as well as on how the other parties support the minority Liberal government’s spending initiative.

The external accounts are likely to improve modestly. The OECD sees the current account deficit narrowing to -1.1% of GDP in 2020 and -0.8% in 2021 from an estimated -1.6% in 2019. Exports contracted y/y for five straight months before growing a most 1.9% y/y in November. Imports have also contracted, limiting the deterioration in the trade balance. The 12-month trade deficit bottomed in June and has increased modestly for four straight months before falling in November. Lastly, Canada’s Net International Investment Position has risen to nearly 37% of GDP, the highest on record. As such, Canada’s external vulnerabilities remain quite low.

 

INVESTMENT OUTLOOK

Both Brent and WTI oil have given up about half of their moves from the October lows to this month’s post-Iran attack highs. Iran tensions have cooled and so oil prices have come down from those highs. Both have since stabilized near their 200-day moving averages near $64.20 and $57.80, respectively. However, the situation is by no means settled and so markets should be prepared for period spikes in oil prices. Studies show that amongst the majors, CAD has the highest correlation with oil prices at .306 for Brent and .362 for WTI.

The Loonie continues to outperform after a poor showing in 2018. In 2018, CAD fell -8% and was the second worst performer in the majors behind AUD at -10%. In 2019, CAD rose 5% and was the best performer in the majors. So far in 2019, CAD is -0.5% and is the second best performer in the majors behind CHF at +0.2%.

On December 31, USD/CAD traded at its lowest level since October 2018 near 1.2950. It has since risen as the US dollar has strengthened broadly so far in 2020. With the greenback recovery expected to continue, we believe the pair will move higher to test the December 25 high near 1.3180. Retracement objectives from the December drop come in near 1.3040, 1.3065, and 1.3095. The 200-day moving average is currently near 1.3240.

Canadian equities are performing in line with the rest of DM after underperforming the last two years. In 2018, MSCI Canada fell -12.8% compared to -11.5% for MSCI DM. In 2019, MSCI Canada was up 19.3% vs. 25.8% for MSCI DM. So far in 2020, MSCI Canada is up 2.2% vs. 2.1% for MSCI DM. With growth likely to remain sluggish, we expect Canadian equities to go back to underperforming, as suggested by the UNDERWEIGHT on Canada generated by our DM Equity Allocation model.

Canadian bonds are outperforming. The yield on 10-year local currency government bonds is -14 bp YTD and is ahead of only best DM performers Australia (-19 bp), UK (-17 bp), and Hong Kong (-15 bp). If inflation remains low and the BOC continues to lean dovish, Canadian bonds should continue to outperform. Our own sovereign ratings model shows Canada’s implied rating steady and solidly at AAA/Aaa/AAA.