BoC’s inaction stuns market

The Bank of Canada has surprised forecasters by refusing to cut interest rates Tuesday morning, leaving the key overnight rate at 3%. Most analysts had predicted a 25 basis point cut in the trend-setting rate. The Bank rate remains at 3.25%.

In making the decision, the Bank cited an increased risk of inflation, particularly skyrocketing energy prices, which have gathered steam since the BoC’s April Monetary Policy Report. While exports to the U.S. have fallen, the economy has been supported somewhat by demand from the rest of the world.

“At the same time, many of the downside risks to inflation identified in the April MPR have eased, while the evolution of credit conditions has been in line with expectations,” the Bank said in a statement. “The risk remains that potential growth will be weaker than assumed.”

After a slowdown in the first quarter, the economy is expected to pick up through the rest of the year and accelerate in 2009. Much of that growth, however, relies on the Bank’s prediction that demand from the U.S. will return.

“Having lulled investors into universally believing that a final rate cut was coming, the Bank of Canada stunned markets by doing nothing at all,” said Avery Shenfeld, senior economist at CIBC World Markets. “And while it always has the liberty to change its mind down the road — as it showed dramatically today — the word from Carney’s team today was that it is satisfied with rates where they are, and no longer judges further easing to be ‘likely.'”

Douglas Porter, deputy chief economist for BMO Financial, says it’s apparent that the threat from headline inflation — which includes energy prices — is more a concern to the Bank than stagnating growth is.

“The Bank did go on to say that core inflation would remain below 2%, but the Bank’s focus on headline inflation is notable. Soaring oil prices matter,” he says.

In its rate decision, the Bank noted that if current levels of energy prices persist, total CPI inflation will rise above 3% this year.

Porter says the Bank’s decision to fight headline inflation is reasonable, but what he finds surprising is the lack of communication from the BoC on its inflation concerns.

“You have almost every single analyst calling for a rate cut. The markets were completely priced for a rate cut, and the Bank is doing nothing. It’s almost unheard of to have market analysts so universally wrong,” he says. “I can see the reasoning for why they didn’t cut rates, but in an ideal world, it would have been better if they had communicated some of those concerns about inflation ahead of the rate decision today.”

Shenfeld notes that while the BoC had not dropped any hints to the market before today’s rate announcement, this move may be a hint of what to expect when the U.S. Federal Open Markets Committee makes its next rate decision.

“While this is only little ol’ Canada, Governor Carney’s decision may be telling in terms of what central bankers are saying to each other in terms of inflation, growth and the ability of the financial system to weather the current storm,” Shenfeld says. “If the Bank of Canada is willing to be patient, having only eased to 3% and having seen a drop in real GDP in Q1, then the Fed is likely to be similarly patient with rates down at 2% and a negative quarter in store for Q2. We no longer expect Bernanke to come through with a final U.S. rate cut even if growth disappoints.”

Shenfeld suggests these may be the first signs investors have been looking for to start bracing themselves for a long-awaited period of fiscal tightening.

“The markets are also on the mark in beginning to brace themselves for the coming tightening cycle. The only issue is when,” he says. “The futures market expects the Fed to have hiked a quarter point by October, which seems improbably early with an election set for November and both housing and the financial system still on shaky ground. We could get a rally in short-term yields before seeing the big sell-off in 2009.”

Guy LeBlanc, vice-president and director of fixed income at Bissett Investment Management, is skeptical of a rate increase in the fall because the fundamental indicators, particularly wage growth, simply are not there.

“For money market investors, this is good news because rates are higher than yesterday, and they are not going to be lower by the end of the summer,” he says.

Instead, he expects the rates to remain flat over the period, which makes government yields appealing over the short term.

“We think for the moment that the sell-off is almost like a good reason to look to extending portfolios by buying longer-duration bonds. Right now a 10-year bond in Canada is close to 4.00%, so they are 95 basis points over funding rate,” he says. “If our view is correct that the Bank of Canada could be on hold a longer period, then you’re getting 95 bps to 100 bps to extend your portfolio. We were at 3.35 and 3.40 at the end of March. That’s a decent backup rate.”

Flat rates also mean managers have to find other sources of yield. LeBlanc, who is the lead manager of Bissett Bond Fund, says because of the looming presence of headline inflation, Bissett has been transitioning its holdings toward real return bonds and is increasingly looking at corporate debt for higher yields.

“Over the last two or three weeks, we’ve had a shorter-duration bias on the regular bond fund. In May, we increased our exposure to real return bonds as an inflation hedge. As corporate spreads have reached all-time highs on a spread basis over the last few months, we started to increase our exposure to high-yield bonds, he says.” We launched the Bissett Corporate Bond Fund about 18 months ago. We think corporate bonds will stabilize, so that’s a fund we’ve started to introduce to advisors as one that should do well and outperform government counterparts.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(06/10/08)

Mark Noble