Recent oil price falls (and prospects of more) combined with a sequence of disappointing real-side data, seeming to contradict Poloz’s “faster not larger” view, mean that a dovish Bank of Canada surprise seems likely on 15 July (when the Monetary Policy Report is released). Markets seem to be pricing in around a 50% chance of a rate cut, whereas my subjective probability would be closer to 70% based upon BoC acting on risk-management grounds given the disproportionate costs of sliding into recession. January’s “insurance policy” needs increasing to once again get ahead of the curve. At the least a very dovish press conference, with a strong hint of future easing and a substantial downgrade to the 1.9% 2015 growth forecast, should be expected. That should particularly support USDCAD and GBPCAD.
“Faster not larger” looking overly optimistic for Canada
The BoC’s view since April has been that the negative impact on the Canadian economy of the 2014 oil price drop would be “faster not larger” i.e. have a front-loaded impact with the economy commensurately starting to show signs of life in Q2 after the “atrocious” Q1. Poloz has stressed that non-energy exports will lead the bounceback, especially sectors sensitive to CAD movements and exposed to the prospective US upturn. Unfortunately, there have been several negative developments since the BoC opined on May 27 that the degree of monetary policy stimulus remained appropriate.
First, oil prices have weakened again in recent weeks. So another round of declining income, wealth and consumption generated by the lower terms of trade plus sharply curtailed oil and gas investment plans are set to hit Canada. While WCS oil prices remain about $5 above the lows prevailing around the January BoC rate cut they have already unwound around half of subsequent rise and further oil price falls look likely given: (i) the latest global growth downgrade by the IMF; (ii) the IEA warns of “massive oversupply” of oil, with the Energy Intelligence Group estimating supply to be at a ten-year high; (iii) the prospective lifting of Iranian sanctions with today’s nuclear deal will bring Iranian oil to the market. This suggests that the BoC should try and get ahead of the curve, emulating the Riksbank’s recent strategy.
Second, Canadian real-side data have serially disappointed. The GDP fall in April was the highest-profile disappointment and within that it is notable that the general GDP weakness is broader than the oil-producing sector. The services-producing sector is the strongest, but 0.6% yoy growth is paltry even there. But manufacturing orders and shipments have weakened and the IVEY PMI has fallen back after giving some tentative cause for optimism. The labour market shows little signs of substantial improvement, notwithstanding the slightly smaller than expected fall in employment last month. But the trade balance also experienced a record deficit. And non-energy exports show no signs of picking up and have actually been weaker than energy exports. This will particularly disappoint the BoC given the weight they have placed on it.
Third, forward-looking indicators also appear weak. Investment prospects look very weak judging by the negative 2015 growth rates reported in the 6 July Statistics Canada survey. Moreover, the negative picture is apparent in both the energy and non-energy sectors, providing little optimism about any rebalancing of the economy. On top of that, the forward-looking components of the latest BoC Business Outlook Survey bounced back by disappointingly-small amounts. The prices balances also fell further, consistent with downward pressure on inflation.
The export weakness probably partly reflects the under-performing US real-side data in recent months, undermining Poloz’s scenario of Canadian exports growing thriving on the back of a resurgent US economy. But the BoC may also have been too optimistic about the trade benefits of FX depreciation (evidence suggests that demand elasticities exceed price elasticities). And it is also notable that the CAD REER remains elevated, especially on a relative unit labour cost basis. In other words, Canada may well be suffering from a fundamental competitiveness problem. Indeed, USDCAD is only around 3% higher than on 21 January, whereas the CAD TWI is only around 2% weaker. So further CAD weakness, prompted by a BOC rate cut, would be helpful for rebalancing the Canadian economy.
And it is notable that both USDCAD and GBPCAD are closely correlated with short-rate differentials, so both would be expected to rise on a dovish BoC surprise, particularly a rate cut with hints at further action if necessary. USDCAD entry levels should be more attractive after today’s weak US retail sales. GBPCAD rise is somewhat contingent on my expectation of another decent labour market report, although GBP’s Carney-inspired jump today may limit the upside.
Activist central banks in an asymmetric risk world
The main arguments against a rate cut are: (i) there remains hope that the turnaround will become more apparent as further Q2 are released i.e. it’s a bit early to completely write off Q2; (ii) low Canadian inflation isn’t yet a problem, at least when the core measures are examined; (iii) cutting rates risks further stoking financial imbalances (household debt is one of the key financial system vulnerabilities identified in the BoC FSR).
And in normal, pre-crisis, times those arguments would probably have held sway. But they seem substantially less likely to do so in the current uncertain environment, where the costs of keeping monetary policy too tight for too long exceed those of it being too accommodative.
This helps explains why smaller Central banks have become increasingly active in managing downside risks, most recently with the Riksbank’s 1 July rate cut and QE extension (notably despite acknowledging that “Inflation is rising and economic activity in Sweden is continuing to strengthen”) and the surprise 10 June RBNZ rate cut. Indeed, the BoC has previously shown itself to be in the activist central bank camp – their 21 January 25bp rate cut was not predicted by any economist. As such, BoC will less reluctant to admit that their judgement looks open to question and consequently take prompt risk management preventative action, even if the Q2 data are partial. BoC have also argued that (iii) should not inhibit a “life-saving surgery” rate cut, as macro-pru policies are used to mop up any resulting financial imbalances.