Cautious Bank of Canada holds interest rate steady, signals economic tests lie ahead

October 31, 2019 Wesley Blight

The Bank of Canada's decision to leave their key overnight rate at 1.75% surprised no one this week as it reinforced the impact of slowing global growth on the Canadian economy.

Ongoing geopolitical issues and trade tensions have weighed on business investment and trade while weakening manufacturing production. Here in Canada, economic growth is expected to slow after reaching an unsustainable high in the first half of the year.

Mixed news regarding growth expectations

A bright spot: consumer spending and domestic demand has helped to soften the impact of slowing trade, fueled by lower borrowing rates and a strong labour market. That's good news for Canada and, relative to July's Monetary Policy Report, the Bank of Canada has raised its economic growth expectations for Canada this year to 1.5% from 1.3%. The picture looks dimmer for 2020 and 2021, however, with expected growth dipping lower (to 1.7% from 1.9% and 1.8% down from 2.0% respectively).

Inflation remains in check

The Bank's target measure of core inflation remains close to 2.0% but the dip in growth expectations reflects a gap between the pace of economic expansion and productive capacity—that's expected to reduce inflationary pressure over the next 12 months, albeit modestly, before ticking back up to 2.0% in 2021.

Canadian economy will be “tested"

The Bank affirmed that “the resilience of Canada's economy will be increasingly tested" and it underscored the potential for ongoing trade conflicts and growing uncertainty to negatively impact business spending, reduce export demand, and weaken commodity prices. Hence, a rate cut is likely as the Bank seeks to support growth. At the same time, cheaper borrowing costs remain a concern given the already elevated debt levels of Canadian consumers.

The Bank made it clear it will be looking closely for signs of resilience in the Canadian economy in the months ahead (consumer spending and housing activity primarily) as it continues to monitor the impact of the global slowdown.

Immediate market impact

Following the announcement, the S&P/TSX Composite Index moved higher and the Canadian dollar fell relative to the U.S. dollar. Canadian bond prices rose, further inverting the domestic yield curve. Even though Canadian bond yields fell this morning. they remain higher than they were two weeks ago. That reflects, in part at least, a perceived reduction in geopolitical risk, a modest increase in production activity, and a lower probability of a global recession.

With the U.S. Federal Reserve cutting its target rate range shortly after the Bank of Canada's decision to hold steady, the Bank of Canada now has the highest interest rate among the G7 economies. We believe that will support the relative performance of the Canadian dollar and contribute to expectations for a future rate cut—the Bank has certainly left room to do so if needed.

To summarize, the Bank's decision and rationale are all within our expectations and no major adjustments to our strategy are required at this time. As interest rates decline back towards all-time lows, fixed income risk has moved higher. We have proactively repositioned our fixed income portfolios to reduce duration and focus on capital preservation.

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.

About the Author

Wesley Blight

Wesley Blight, CFA, CIM, FCSI, is an Assistant Vice President with the Investment Management and Strategy team at MD Financial Management. He is responsible for the investment results of the firm’s fixed income and multi-asset products.

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