The Bank of Canada (BoC, the Bank) announced this week that it will continue to hold its target overnight interest rate at 1.75%.
In total, the Bank says Canada's economy is operating close to its potential and inflation is on target. That said, escalating trade conflicts and the related uncertainty are taking a toll on the global economy. The Bank says in this context, the current degree of monetary policy stimulus remains appropriate for the time being.
Trade conflicts weigh on investment
“As the U.S.-China trade conflict has escalated, world trade has contracted and business investment has weakened," the Bank said in its statement released Wednesday morning. “This is weighing more heavily on global economic momentum than the Bank had projected in July."
Although U.S. growth remains supported by consumer and government spending, commodity prices have come down as concerns about global growth prospects have increased. “These concerns, combined with policy responses by some central banks, have pushed bond yields to historic lows and inverted yield curves in a number of economies, including Canada."
Growth beats expectations, temporarily
While Canadian growth in the second quarter (3.7% annualized) exceeded the Bank's expectations laid out in July, it says some of this strength is expected to be temporary—the rebound was driven by stronger energy production and robust export growth, both of which were simply recovering from very weak performance in the first quarter. Business investment contracted sharply after a strong first quarter, thanks to heightened trade uncertainty. Wages, meanwhile, picked up during the quarter, boosting labour income, but consumption remained unexpectedly soft. “Given this composition of growth, the Bank expects economic activity to slow in the second half of the year," they write.
Housing activity also regained strength more quickly than expected as resales and housing starts caught up to underlying demand, thanks to lower mortgage rates. Although this could add to already high household debt levels, the Bank says recent policy changes—changes to mortgage underwriting rules—are expected to support a more sustainable balance in the future.
This announcement, acknowledging that future economic growth is expected to be less robust than recent data suggests, is perhaps one of the most important signals the Bank is sending: Future rate cuts are perhaps on the horizon, much in line with market expectations (Markets are currently expecting an interest rate cut by the end of this year).
Markets react to the news
In investing, the year-to-date decline of interest rates has been positive for fixed income returns and has provided some support to equity markets as well. Returning rates to historically low levels as central banks provide further monetary support, provides a backstop for the economy and a helpful boost for stocks (supported by lower rates on mortgages, corporate lines of credit and more).
The announcement is clearly aligned with market and our own expectations as the path to lower rates in the near future has been cleared. The Canadian dollar rose modestly in response to the news. Although not heavily influenced by the BoC announcement, equities also moved higher and Government of Canada bond yields moved slightly lower.
In summary, the Bank's decision and rationale are all within our expectations and no major adjustments are required at this time to our strategy. For more information about the BoC's announcement, interest rates in general or your portfolio, please contact your MD Advisor*.
*MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec), or an MD Private Investment Counsel Portfolio Manager.