More BoC hikes on the way: Experts

This morning’s announcement from the Bank of Canada that it was raising its benchmark policy rate to 0.75% caught few Canadians by surprise.

Members of the Canadian financial industry stress it is a sign that the country’s economy is going strong and that further rate hikes must be expected.

“I think the comments from the BoC were cautious and dovish,” says Jean Charbonneau, senior vice-president and portfolio manager, AGF Investments Inc. He says the Bank is really looking at what’s happening around the world, “although Canada has been doing relatively well in terms of the housing market, consumption, employment and many aspects of our economy, relative to many other economies including our neighbours and Europe.”

With GDP growth projections revised to 3.5% for this year, and 2.9% and 2.2% in 2011 and 2012 respectively, the BoC expects the economic recovery in Canada to be more gradual than it had projected in its April Monetary Policy Report.

Those earlier predictions had placed growth at 3.7% for 2010 and 3.1% in 2011.

This is indicative of a weaker global recovery and a more modest consumption growth in Canada, says Charbonneau. “Even though we’ve been relatively robust in our economy, the BoC is looking at broader issues. The recovery will take much more time than what was originally forecast earlier this year.”

This, he says, forms the basis for further adjustments in the monitory policy in Canada.

“There are still two more hikes priced in by the year end,” says Charbonneau, adding that “the BoC will be extra cautious in getting too far ahead in normalizing its interest rate policies if things don’t pick up elsewhere.”

With a rate hike of 25 basis points, we are still in an accommodative territory, says Stephen Lingard, co-lead manager of Franklin Templeton’s Quotential program. “This remains an extremely simulative monetary policy.” He says it makes perfect sense given the overall global economic weakness, in addition to the fact that there still exists a significant output gap in Canada and the rest of the world.

“I think in some way the BoC is trying to normalize interest rates, sneaking in some rate increases before the environment softens again towards the end of the year and even into next year.”

The Bank justified the hike rate, saying it “leaves considerable monetary stimulus in place, consistent with achieving the 2% inflation target in light of the significant excess supply in Canada, the strength of domestic spending, and the uneven global recovery.”

In other words, the BoC has taken the opportunity to increase interest rates while things are still good in Canada.

“Obviously the central bank wants to have the latitude to raise and lower interest rates,” says Lingard. “The problem is that when you sit on 0% interest rate, you’ve basically exhausted that form of stimulus.”

The strength in Canada’s domestic economy is likely to persist, meaning that the current “emergency level” of rates is no longer warranted. “Our forecast is that the overnight rate will be 1.25% at the end of 2010 and 2.75% at the end of 2011, higher than the rates implied by the futures market,” says Lingard.

Given the market reaction, it’s clear that the move itself had no element of surprise. However, Bank Governor Mark Carney’s suggestion that future rate increases were not “preordained” puts a damper on the market.

“I do know a number of brokers have taken down their target from 1.25% by the end of the year to 1%,” says Lingard. Higher interest rates attract capital, which generally leads to a stronger currency. “So the currency weakness we’ve seen today has less to do with the move and more to do with the BoC outlook, which seems to be a little bit more cautious.”

Lingard says this is expected to impact advisors from the currency perspective and what growth looks like going forward.

The BoC has two more policy meetings scheduled before the end of the year.

“We expect the Bank of Canada will increase its overnight rate by 25 basis points for a third time in September, before pausing for the remainder of the year owing to global concerns,” says Michael Gregory, BMO senior economist.

Industry experts caution that while there might be one or two more rate hikes on the cards, we are still far from full normalization of interest rates.

(07/20/10)