BoC get on with in, but now watching more carefully; implications for RBA

The Bank of Canada hiked rates today to 1.0%, delivering back-to-back 25bp hikes on 12 July and now 6 Sep.  Quite remarkable in light of the glacial pace of hikes in the US and cautious tone in policy around the world.

They are removing considerable policy accommodation.  Rates were very low, and today reverses the emergency cuts in 2015 taken to offset the oil price shock.

The BoC has estimated that neutral rates are around 3%, so from their perspective rates are still very accommodative.

The RBA and RBNZ have argued that the policy moves abroad, like this one, have limited implications for their policy, because they didn’t take policy to the same extremes in accommodation in the first place.

The RBA also worked hard to downplay its research that neutral rates are around 3.5%, saying it had little implication for its policy deliberations.

It is worth noting that Australia and Canada now have the same degree of interest rate accommodation, judging by their central bank’s perception of neutral rates.

BoC is in the process of removing accommodation, the RBA is in less hurry.  This may be consistent with the degrees of slack in their relative economies, but the hike in Canada does tend to make you think that the RBA will need to consider removing accommodation before it reaches full-employment, or else face the prospect of needing to raise rates quickly causing disruption to its economy.

I wrote in my report yesterday that the BoC was more likely to hike than not today, but I was not prepared to buy CAD ahead of the report.  The bottom line is that I was not confident enough in this call, and the risk-reward was not particularly favourable, given that the market appears quite long CAD anyway, and the CAD has already rallied a long way this year.

Even though the BoC’s model approach suggested a hike was likely, it is still a big call to deliver back-to-back hikes in the current global environment of low rates and low inflation.  There is also increased uncertainty around North Korea and US politics.

The BoC statement suggests that the hike was indeed driven by their output gap model of inflation.  The key factor appears to be that, “the level of GDP is now higher than the Bank had expected.”  The Bank had forecast the output gap to close by the end of this year, but with a higher starting point for GDP, even with the expected moderation in growth, the output gap is set to close before year end. The Bank may well have judged it to be now closed.

The statement noted the strength in the exchange rate, but did not say it was a restraint on rates policy.  It merely implied it was a consequence of relative strength in the Canadian economy and a weaker USD.

As you would expect, the statement acknowledged risks in the global outlook, and interestingly blamed them for a weaker USD.  It said, “significant geopolitical risks and uncertainties around international trade and fiscal policies remain, leading to a weaker US dollar against many major currencies.”

Canada faces specific risks on trade as NAFTA is being renegotiated.  But the BoC and it seems the market is not showing all that much fear that it may undermine Canadian exports.  It is only paying lip-service to the risk at this stage.

The Bank implied that inflation is on its forecast track to return to the 2% target around mid-2018, encouraged by the recent uplift in July. It said, “While inflation remains below the 2 per cent target, it has evolved largely as expected in July. There has been a slight increase in both total CPI and the Bank’s core measures of inflation, consistent with the dissipating negative impact of temporary price shocks and the absorption of economic slack.”

Their outlook suggests that further hikes should be expected, but the Bank made it clear that it is not on a pre-set path and will be guided by the data.  It named some specific factors that may slow further hikes.

It said, “There remains some excess capacity in Canada’s labour market, and wage and price pressures are still more subdued than historical relationships would suggest, as observed in some other advanced economies.”

And, “Given elevated household indebtedness, close attention will be paid to the sensitivity of the economy to higher interest rates.”

This last note of caution on household debt is significant.  It suggests there is some heightened home-grown uncertainty, and the market should be watching closely how households and the housing market respond to rising interest rates.

The parallels with Australia and New Zealand are strong on this front.  The RBA is already talking much about households and their debt.

The tone of this statement suggests that the BoC will now move more cautiously on future hikes.  Perhaps we should be looking to fade strength in the CAD against currencies like the AUD.  However, it is still not clear that the market has enough hikes in the Canadian yield curve, and there is still little evidence that higher rates are cutting much into Canadian household confidence.

If the Australian economy continues to show strength, I think the Canadian rate trend will start to influence market thinking on the RBA.  Of crucial importance will be the state of consumer spending, where sentiment remains rather downbeat in the market and by the RBA.

This brings into focus the retail sales data due later today.

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Greg Gibbs,
Founder, Analyst and PM
Amplifying Global FX Capital Pty Ltd