BoC rate cuts hint at deepening crisis

Against a backdrop of fears that the economic crisis could deepen, the Bank of Canada did what banks around the world continue to do — cut rates. Canada’s overnight rate now stands at 1%, prompting many analysts to ask, How low can rates go, and how long will they last?

In its brief reasoning for the rate cut, the BoC noted, “The outlook for the global economy has deteriorated since the Bank’s December interest rate announcement, with the intensifying financial crisis spilling over into real economic activity.”

Taken in isolation, this statement would suggest the BoC has revised its outlook from cheery to dreary. Douglas Porter, deputy chief economist at BMO Capital Markets, points out the BoC’s last report was also downbeat, inferring the BoC sees more risk to the economy.

“The outlook was already quite gloomy in early December — we had just seen the deep job losses for November — and the Bank says the outlook has deteriorated further since then,” he wrote in an analysis of the rate cut.

The BoC said that if worldwide efforts by the world financial banks to stabilize the world financial system are successful, there will likely be a recovery in 2010.

“Stabilization of the global financial system is a precondition for economic recovery. To that end, governments and central banks are taking bold and concerted policy actions. There are signs that these extraordinary measures are starting to gain traction, although it will take some time for financial conditions to normalize,” the Bank writes. “As policy actions begin to take hold in Canada and globally, and with support from the past depreciation of the Canadian dollar, real GDP is expected to rebound, growing by 3.8% in 2010.”

Porter believes this outlook is overly optimistic.

“What really stands out is their call for 3.8% growth in 2010, revised up from 3.4% in October, and about double our view,” he says. “The big bounce helps explain why the Bank sees inflation getting back towards target by 2011.”

In case things start to deteriorate further, the BoC made clear it is ready to continue slashing rates.

“[The] Bank has left the door open for the possibility of further rate cuts, and with a wave of ugly data no doubt bearing down on the Canadian economy and markets reeling yet again, a move below 1% looks increasingly likely,” Porter says.

What is unclear is the effect rate cuts will have on global inflation. There seems to be two schools of thought right now — both negative. One school believes we’re entering a period of protracted deflation, which is generally associated with depressions or long, deep recessions, and that rate cutting will ease things but not solve them. The other school argues the deep rate cuts and excess printing of money will lead to hyperinflation.

On the deflationary side of the debate is David R. Rosenberg, chief North American economist for Merrill Lynch. In a report released Tuesday, Rosenberg warned investors to consider deflation the norm, rather than a short-term exception. In the case of the U.S., he believes it will take a considerable amount of stimulus to revive prices.

“While the government is rapidly expanding its balance sheet and the Fed is dramatically boosting liquidity, these are only a partial offset to the fact that the $50 trillion household balance sheet is contracting at an unprecedented rate, and it is the household that ultimately determines the demand for, and pricing of, the goods and services that comprise the consumer price index,” he says. “It will literally take years of fiscal and monetary pump-priming to bring these measures of economic slack to levels that will precipitate the next inflation cycle.”

Even though rates look low, Rosenberg believes fixed income instruments and government bonds remain a solid investment class for the foreseeable future.

It will not take much in the way of even further reduction in yields to generate high single-digit returns for long-term bonds given the convexity at low levels of interest rates,” he says. “The odds of a bear market in the fixed-income market, given how long this recession is going to last and how muted the recovery is likely to be thereafter, even after accounting for all the government stimulus, is quite remote in our view.”

You don’t need a recovery to kick-start an inflationary cycle. If an economic crisis deepens, and fiscal stimulus from the central banks is unsuccessful, there can be downward pressure on currencies. Essentially, economies end up in deep recession accompanied by declining value of money. That’s the thesis put forth by well-known fund manager Eric Sprott, the president and CEO of Sprott Asset Management.

According to Sprott’s December market commentary, the world economy is in a depression, and the ability of central banks to solve the issue through rate cuts and stimulus is likely to have little impact.

“Monetary policy has been little more than a sugar-coated placebo,” he writes. “Credit is neither cheap nor plentiful. Just ask the Bank of Montreal, one of the big banks in the highly admired Canadian banking system that recently did a bond issue (not stock, not preferred, but straight-up plain-vanilla bond) at a 10% interest rate. Central bank interest rate policies have become irrelevant.”

Sprott argues that downward pressure on currencies will take hold.

“In its desperate attempts to reflate the financial system, the ultra-aggressive policies and programs of the Federal Reserve (to date the most aggressive central bank in the world) also promise to ultimately debase the dollar as a store of value,” he says. “At a zero fed funds rate and [with] quantitative easing now in full force, the Fed has entered the realm of experimentation in uncharted territory, having gone well outside the rules.”

That leaves gold as the only real asset class that will be a store of value in 2009, Sprott believes.

“Any fiat currency is only as good as the faith people have in its central bank. In 2009, we believe this faith will be severely tested, especially in a depression scenario, where the desire for competitive debasement may be too tempting to resist,” he says. “Going into the depression of 2009, gold may well be the only safe harbour asset.”

(01/20/09)