Earlier today, the Bank of Canada (BoC) announced that it would increase the target overnight rate to 0.75% from 0.50%—the first rate hike since September 2010.
The decision was widely anticipated as Deputy Governor Carolyn Wilkins hinted that an increase was probable in her speech back in June. Even though the target overnight rate has increased, it remains accommodative and supportive for Canada’s economy.
Looking forward, the market is expecting a second 0.25% increase within the next 12 months.
Productivity and growth
The BoC points to economic productivity increasing much quicker than previously expected as the key reason for its decision. It is now expected that the output gap will close at the end of 2017 rather than early 2018 which was reported in the April Monetary Policy Report. The strong Canadian growth in the first quarter of 2017 is expected to moderate over the rest of the year, but remains above potential. Expectations for GDP growth are now 2.8% for 2017, 2.0% for 2018 and 1.6% for 2019. April’s expectations were 2.6%, 1.9% and 1.8% respectively.
Growth is still projected to be low, but sources of growth are broadening beyond debt-fuelled consumption and will be supported by more sustainable growth from exports and business investment. The BoC also points to solid growth in the U.S. and Europe, but note the risks of geopolitical uncertainty.
Inflation remains low and the BoC believes this is temporary, pointing at food price competition, electricity rebates and changes to automobile pricing as examples that may have caused further short-term inflation decline. The BoC expects inflation to return close to the 2.0% target by mid-2018. At MD we have some concerns that if this assessment is incorrect, increasing rates too aggressively now may cause an inadvertent slowdown in the Canadian economy.
In our opinion, the hike can be seen as a step towards unwinding the emergency stimulus provided by the BoC since 2015 due to the decline in the price of oil. While the price remains low and is likely range bound for the foreseeable future, the BoC believes the energy sector has had sufficient time to adapt and is now positioned to support future growth. We at MD do not necessarily agree as the price of oil is below production costs for Canadian producers and a stronger Canadian dollar presents another headwind.
Additionally, MD will continue to watch for material changes caused by the rate increase on ongoing concerns about Canada’s real estate market and consumer spending habits.
It is important to keep in mind that even though rates are rising and are expected to continue to do so, the BoC’s policy stance remains quite accommodative—rates are still low and are simply coming off all-time lows.
What does this mean for MD portfolios?
With expectations set, markets had generally “priced in” the hike and had already reacted to the news—we’ve seen bond yields rise leading up to the announcement and the Canadian stock market is the only major developed market that has delivered year-to-date negative returns. With that being said, the impact of today’s decision on MD portfolios and funds is nominal—our ongoing investment management process ensures we are suitably positioned.
On Friday, we will publish an article that will explore the implications of rates starting to trend upwards on your investment portfolio and the broader impact of higher rates on fixed income, mortgages and borrowing in general.
We encourage you to contact your MD Advisor if you have any questions.