- The Bank of Canada’s target for the overnight rate remains at 0.25%.
- Heightened inflation should ease back towards 2% in the second half of 2022.
- The Omicron variant has injected renewed uncertainty.
Unsurprisingly, the Bank of Canada (BoC) decided to hold its target for the overnight rate at 0.25% during its December interest rate announcement. Also confirmed, the BoC will continue with the reinvestment phase of its quantitative easing program – only buying Government of Canada bonds to replace maturing assets.
The Bank reiterated that it remains committed to holding on interest rates until economic slack is absorbed, and its 2% inflation target is sustainably achieved. The BoC expects this to happen sometime mid-2022. We expect the overnight rate to head higher over the next 12-months; however, the market implied five rate hikes are more aggressive than we anticipate.
Added uncertainty from the Omicron variant
Globally, accommodative financial conditions continue to support economic activity and the recovery.
Noted from the Bank’s release, “economic growth in the United States has accelerated, led by consumption, while growth in some other regions is moderating after a strong third quarter. Inflation has increased further in many countries, reflecting strong demand for goods amid ongoing supply disruptions. The new Omicron COVID-19 variant has prompted a tightening of travel restrictions in many countries and a decline in oil prices, and has injected renewed uncertainty.”
Canadian growth is in line with expectations
In line with the Bank’s own estimates, Canada’s economy grew by 5.5% in the third quarter, driven by “a rebound in consumption, particularly services, as restrictions were further eased and higher vaccination rates improved confidence.” Employment gains were a plus, but job vacancies remain elevated.
Working against growth were the persistent supply chain bottlenecks that continue to dampen GDP components like non-commodity exports and business investment.
The BoC also noted that the B.C. floods and the spread of the Omicron variant could “weigh on growth by compounding supply chain disruptions and reducing demand for some services.”
Inflation still being boosted by recovering demand and supply disruptions
Global supply chain disruptions continue to drive up prices. It is the Bank’s and our expectation that these supply constraints will take some time to resolve, but inflation should ease towards 2% in the second half of 2022.
Notably, gasoline prices which have pushed measures of inflation higher, have come down recently.
Interestingly, the BoC has dropped the word temporary from its description of inflation, indicating that recent inflationary pressures are more stubborn than previously believed. The Bank restated that it “is closely watching inflation expectations and labour costs to ensure that the forces pushing up prices do not become embedded in ongoing inflation.”
Recent tweaks to positioning
Shortly following the announcement, we saw Canadian government bond yields slip slightly. The Canadian dollar which was trading slightly higher versus the U.S. dollar declined marginally following the announcement. The S&P/TSX Composite Index traded lower following the announcement, as did foreign markets, signaling the cause was likely related to building Omicron uncertainty.
Within our portfolios, we remain underweight fixed income relative to equities. Within our fixed income exposure, we continue to hold a moderately shorter than benchmark duration position. We have recently removed our yield curve flattening position as further upside is limited and we have introduced a position with expectation that short-term U.S. bond yields will rise by a larger amount than short-term Canadian bond yields.
While we are still overweight equities overall, it is worth noting that this overweight has trended downwards in recent quarters as the tail winds that have propelled stocks higher are beginning to fade. Within equities, we prefer developed, North American equities versus emerging market equities. For more information about this, please contact your MD Advisor.
The BoC’s next interest rate announcement is scheduled for January 26, 2022 and will be accompanied by the latest Monetary Policy Report.
* MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec).
The above information should not be construed as offering specific financial, investment, foreign or domestic taxation, legal, accounting or similar professional advice nor is it intended to replace the advice of independent tax, accounting or legal professionals.