Volatility continues to rule financial markets as world central bankers keep playing mind games with investors by positively surprising, not only in terms of timing but in quantity as well. The net result is a 2-3% rally in global risky assets this week. Regarding the ECB, the central bank delivered more than expected and investors should read the sharp depreciation of the euro vs. the Japanese yen as a gauge of short-term success. Why? Because Europe and Japan’s exports are competing for the Chinese market. EUR/YEN depreciation should rebalance the market share that Europe has lost over the past few years. In our view, this is an important pre-requisite for growth in the euro zone to re-accelerate.
In Canada, the 25bp rate cut by the Bank of Canada (BoC) was unexpected; in hindsight, a policy response was not a question of if but when. Indeed, following the plunge in oil prices, the bond-yield curve in Canada had become too flat at ~50bps, with bond investors pricing a marked slowdown in growth. The BoC acted pre-emptively, sending a clear message that it will fight hard to avoid falling behind the economic-growth curve. In fact, the BoC may have to use the bullets left in its gun over the next year. Indeed, the last two oil shocks in 2001 and 2008 required 300bpts in rate cuts to stabilize Canadian GDP growth. Economic conditions are not as harsh as back then but one could argue that the compounding impact of lower oil prices, households debt deleveraging, and fiscal austerity (in provinces and municipalities) will take its toll on job creation and lead to recession-like conditions. Thus, with 75bps left to reach the zero bound, could the BoC be the next central bank to pursue QE?
For a little more detail on the BofC decision, we have summarized commentaries from our own analysts as well as Eric Lascelles, Chief Economist at RBC.
According to the Bank of Canada, the rate cut was an act of insurance to protect the economy from the impact a sharp drop in oil prices could have on the energy sector and ultimately the implications for Canada’s growth and underlying inflation. The immediate effect of this surprise rate cut was the immediate market reaction of a weakening Canadian Dollar, which declined nearly 2.5% relative the U.S. Dollar, which is a huge single day move for a currency. In addition, bond yields continued to drop to record lows and our equity markets staged a strong intraday rally.
This week’s rate change was the first change in over four years, the first cut in nearly six years and influences everything from car loans to mortgages. Canada’s Chartered Banks have not yet reduced their prime lending rates as they evaluate the impact of even lower rates on their net interest margins, but you can certainly expect to see your cost of borrowing to be reduced in some fashion over the coming week or so.
According to RBC, the Bank of Canada may also have wanted to cut rates in advance of the European Central Bank’s delivery of Quantitative Easing, which they did in earnest yesterday. While the loonie has declined versus the U.S. Dollar over the past six months, it had actually been strengthening against others, and thus the Bank of Canada felt that without this action our Dollar risked being caught in a currency updraft as the Euro weakened.
The Monetary Policy report that accompanied the rate decision also contained useful commentary on the oil market. Globally, our central bank noted that over half of global oil production is uneconomical at $45 per barrel. RBC contends that even at $60 per barrel, approximately one-third of global oil production is uneconomical. This parallels our own views, and would seem to imply that global production should respond accordingly, translating into improved oil prices in the future.
Given the magnitude of the shock in oil prices, there is an exceptional amount of uncertainty about the Canadian economy currently, thus the rate cut, albeit a surprise was a prudent preemptive move by our central bank. However, given the Monetary Policy Report comments, it would certainly not surprise us to see a second rate cut in Canada this year, should the oil prices remain low for an extended period.
Within the policy report that accompanied rate announcement, the Bank of Canada has reduced its economic outlook for 2015 to 2.1%, while actually upgrading its forecast for 2016 to 2.4%. Governor Poloz commented that without the assistance of an easier monetary policy, the Canadian economy could have seen a much greater drop in its GDP
Of course, with these forecasts being partially predicated on oil prices, a quicker rebound in oil prices, which RBC’s chief economist Eric Lascelles believes is a significant probability, could see Canada’s economic growth rebound quite quickly. So, on the bright side, a forecasted lower oil price should also boost global growth, in particular with our largest trading partner, which is in large part the reasoning for the upgraded GDP forecast for 2016.
Next week, aside from the election in Greece, we will focus on US durable goods orders and the FOMC statement. Otherwise, we will also pay close attention to inflation in Europe and Japan.
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The Dekker Hewett Group