The Bank of Canada held rates steady this week, maintaining its target overnight rate at 1.75%. It also revised its projection for real GDP growth in 2019 upwards to 1.3% while calling for 2.0% growth in 2020 and 2021. The revised GDP outlook comes as Canada's economy showed stronger than expected growth in the second quarter due to a reversal in weather-related slowdowns and a surge in oil production.
Global trade tensions dampen outlook
The Bank made its decision to keep rates steady as ongoing global trade tensions—particularly between the U.S. and China - continue to weigh on the global economic outlook. This also reflects views shared by other global policymakers in the developed world who, despite positive near-term prospects for growth in North America, have indicated they might lower interest rates later this year. The Bank expects 3.0% global GDP growth in 2019, strengthening to around 3.25% in 2020 and 2021.
Positive outlook at home
Here in Canada, the economic outlook remains positive despite global trade uncertainty, with a healthy labour market supporting consumer spending along with a stabilizing housing market and a rebound in exports that is set to grow along with expanding foreign demand. Trade conflicts and competitiveness challenges however continue to dampen the outlook for both trade and investment.
Going forward, however, it's not likely the Bank of Canada will be able to raise rates, at least for the foreseeable future. Even with a positive economic outlook here at home, rates will need to rise in line with what the market expects for the U.S. If Canadian rates were to tick higher than those in the U.S., it could drive the Canadian dollar up, creating challenges for exporters and increasing rates for consumers and businesses at a time when business uncertainty is elevated.
Impact of comments from the U.S. Federal Reserve
U.S. Fed Chair Jerome Powell also released prepared remarks to Congress that helped confirm investor expectations. The market expects the Fed to cut rates at its next decision; however, confidence had started to wane after the release of U.S. jobs data last week which suggested a stronger than expected labour market. With trade tension and U.S. government policy uncertainty being elevated, Powell's comments solidified expectations that lower rates are probable.
From a Canadian perspective, however, the announcement has had a positive impact for the Canadian dollar, with our currency appreciating relative to the U.S. dollar.
An inverted yield curve makes raising rates difficult
In April, the Bank of Canada presented a cautious view, with household spending, oil, and international trade tension all weighing on its outlook. This dovishness, along with investors expectations for the global economy has contributed to an inverted bond yield curve in Canada—with short-term borrowing rates being more expensive than long-term rates. Given this reality, the Bank of Canada will find it challenging to raise rates anytime soon.
The challenge is that Canadian short-term economic growth has been very strong. Given the Bank is data dependent, investors could be tricked into thinking higher rates are warranted. However, the Bank was very clear in stating that this short-term growth was supported by temporary factors (oil and the reversal of weather related shutdowns) and that sustainable source of growth were, on balance, supportive of modest growth and low inflation.
The announcement, while widely anticipated, presented a great synopsis of how investors are being influenced by global policy rhetoric today.
In addition to being data dependent, the Bank of Canada is in “wait and see" mode based on what happens with tariffs, trade policies, and central bank decisions from the U.S. and Europe.
Expectations remain that economic growth will slow and uncertainty will be elevated, making it difficult for businesses to plan their spending.—drawing business investment lower and reducing the contribution from Canada's exporters. Consequently, I struggle to see how rates will rise in the foreseeable future without making it even more difficult for the domestic economy.
In the meantime, consumer spending should be well-supported with lower borrowing rates and housing prices should move higher as mortgages will be cheaper. From an investment perspective, risk assets should remain well-supported by lower interest rates. Fixed income won't likely experience a material rise in bond yields, at least in the extreme short-term, but longer term returns will come down as yields have drifted lower year-to-date.
From a portfolio management perspective, we see bond yields remaining low in the near-term with stable borrowing rates set to decline modestly. This should have a positive impact on the performance of bonds in our portfolios.