As expected, the Bank of Canada holds interest rates steady

January 11, 2019 Wesley Blight

           

The Bank of Canada (BoC) announced that it is maintaining its target overnight interest rate at 1.75%, a move that was widely anticipated by those watching markets and the economy.

Although it held rates steady, the Bank says it expects policy interest rates will need to increase over time to a more neutral range (between 2.5% and 3.5%) to achieve inflation targets. The pace of change will depend on how the outlook evolves, in particular with oil markets the Canadian housing market and global trade policy developments.

Shorter term Government of Canada bond yields were little changed following the announcement, while longer bond yields moved slightly higher with the Bank reminding market participants that higher rates will eventually be required. Similarly, the Canadian dollar rose following the announcement, continuing its year-to-date appreciation versus the U.S. dollar.

Oil prices feature prominently in the Bank's announcement

While the Canadian economy has been performing well overall, a global drop in oil prices—benchmark oil prices are about 25% lower than expectations that were published in the Bank's October 2018 Monetary Policy Report—has had an impact on the BoCs Canadian outlook, resulting in lower terms of trade and national income. Investment in Canada's oil sector is expected to weaken in the coming year.

Consumption spending and housing investment numbers have also come in lower than expected. Going forward, the Bank says household spending will be further dampened by slow growth in oil-producing provinces.

Overall, the Bank projects real GDP growth of 1.7% in 2019. It expects to see above-potential growth of 2.1% in 2020 as indicators of demand should start to show renewed momentum in 2019. At the end of 2018, inflation eased to 1.7% in November, thanks largely to lower gas prices. Although the lower Canadian dollar will exert some upward pressure on inflation, CPI inflation is expected to remain below target before increasing towards 2% near the end of 2019.

Global economic growth expected to moderate

Globally, growth is expected to pull back to 3.4% in 2019. The BoC says temporary factors in Europe and Japan affected growth in the second half of 2018, while growth in the U.S. economy remained robust.

In examining some global uncertainties in its Monetary Policy Report (MPR), the Bank points out that the U.S and China have taken some positive steps, but have not yet reached an agreement on trade issues. While growth in the U.S. remains solid, there are increasing signs that the U.S.-China trade conflict is weighing on global demand and commodity prices.

Additionally, the future of Brexit and the unclear plan for the United Kingdom's departure from the European Union, also continues to weigh down sentiment and activity around the world.

Despite many private sector forecasts revising global growth downwards, the BoC made no changes to their forward looking projections. By reinforcing their expectations, the BoC has caused market participants to bid up their expectations and, by extension, longer term bond yields.

Rate hikes not likely in the near future

According to the MPR, the Canadian economy has been operating near capacity for over a year now. Job growth is strong, the unemployment rate is at a 40-year low, and inflation is close to target. GDP growth numbers for the last quarter of 2018 are expected to come in lower, thanks mainly to lower oil prices. Following this “temporary slowdown," which is expected to continue through 2019, the BoC says the pace of economic activity in Canada is expected to move higher in 2020, helped by strong employment, expanding foreign demand and accommodative financial conditions. Business investment and exports outside of the energy sector are also expected to grow steadily.

For now, however, the Bank estimates that output growth in the fourth quarter of 2018 and the first quarter of 2019 will average about 1% as low oil prices and adjustments in the housing market create headwinds to growth. The Bank projects that real GDP growth will pick up in the second quarter of 2019.

The Banks announcement along with the MPR supports our expectations for future rate hikes. However, the BoCs downward revision for 2019 growth means there is more excess capacity than previously expected. This is key to why we believe the pace of anticipated changes is now more moderate with no changes likely for the immediate future. In 2020, the productivity gap is expected to close and, in turn, promote inflation.

For more information about the BoC announcement and what rising rates can mean for you and your portfolio, please contact your MD Advisor.

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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