Expect more surprises from BoC

This morning, the Bank of Canada cut its overnight rate target for the first time since Sept. 2010. The rate’s now 0.75%.

Before today, analysts speculated the central bank wouldn’t nudge rates higher until mid-2015 to coincide with the U.S. Federal Reserve’s expected increase.

But now, oil prices are down about 55% from summer highs, which the BoC says “has increased both downside risks to the inflation profile and financial stability risks.”

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So the bank made the cut.

Jennifer Lee, director and senior economist at BMO Capital Markets, says the rate drop was a surprise because “the Canadian dollar is so weak, and that was already acting as stimulus for economic growth. However, stock markets seem to like the news and there’s usually a rally after these types of events.”

The TSX hit a two-week high following the announcement.

Meanwhile, says Lee, “the Canadian dollar is already trading just below 81 cents, and that’s nearing our forecast of 80 cents by the end of this year. So we’re definitely going back to the drawing board” to revise predictions. “It’s likely the BoC is welcoming a lower loonie in terms of the stimulus it will provide for manufacturing, for example.”

Read: Will Canada outperform in 2015?

A CIBC World Markets report released today predicts the Canadian dollar will hit 79 cents by the middle of this year.

Lower rates, lower growth

The BoC cut its 2015 GDP growth forecast from 2.4% to 2.1%, and it expects growth to average about 1.5% in the first half of the year. Growth will reach 2.4% in 2016 instead.

Yet, CIBC World Markets notes the bank’s projections assume an average oil price of US$60. “GDP growth in the first half of 2015 would average only 1.25% if the [per-barrel] price were just $10 lower,” it says in a report.

As for Lee, “We have oil prices averaging around $55 per barrel this year, and heading to [around] $70 per barrel next year. [So], depending on how prices move, another rate cut could occur. But we hope [the BoC] waits to see how this plays out before it does anything else.”

Read: Canada’s winners and losers as oil prices drop

Outlook for investments

With lower rates, return-hungry clients should consider upping their equities allocations.

“The current yield on Canadian stocks is about 2.66%, whereas Canadian 10-year bonds are yielding about 1.4%,” says Chris Ambridge, president and CIO of Provisus Wealth Management. “That means you can get almost double the returns by investing in big-name [domestic] stocks.”

Further, “In the U.S., the yields of 10-year bonds have dropped below dividend yields. And every time that has occurred in the last 50 years, stocks have rallied more than 30% over the following year. In Canada, the same thing occurs since low yields means people look for alternatives.” With bonds, he says, “clients are looking at almost negative returns [after fees], and then there’s inflation.”

REITs are another option, Ambridge says, since yields are between 5% and 6%. “But you have to remember that most are small-cap stocks and you’re taking on a different level of risk.”

As for fixed income, the outlook is mixed, says Lee.

“Rates are staying at very stimulative levels—even in the U.S. where the Fed is on track to raise rates in the middle of this year. When you’ve got low rates in Europe and now in Canada, there’s so much uncertainty in markets. That means there could be further rallies in safe haven fixed-income markets.”

Read: Let’s keep rates positive

She adds, “The BoC has been firm in its stance that it will do what is right for Canada,” rather than follow the lead of the Fed. Lee predicts the Fed will raise rates in the middle of the year, and that the BoC will follow its own course going forward.

CIBC predicts Canada’s overnight rate will return to 1% in Q2 2016, and jump to 1.25% in Q3 2016.

A look at debt, future rate cuts

If banks lower their lending rates accordingly, borrowers will also benefit – household debt hit a record 162% of disposable income in Q3 2014. And, as The Globe and Mail reports, the bank’s decision could have been “an attempt by [Bank of Canada Governor Stephen] Poloz to shield highly indebted Canadian households from an oil-induced hit to their jobs and incomes—signs of which are already evident in Alberta.”

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Lee says that while lower rates are “good news for consumer spending, higher levels of debt are something the Bank of Canada doesn’t want to see. Frankly, I don’t see how they can cut rates and still complain about debt levels. In fact, that’s almost a reason not to call another rate cut in the near future, but anything is possible.”

“Poloz is delivering this news as an insurance policy and he’s saying that [future rate announcements] are dependent on economic developments,” she explains. “If oil continues to remain weak, he’s saying they could do more or less. [But] he’s putting everything on the table and, at 0.75%, there’s still room to cut rates further.”

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