Inflation is the enemy of fixed income

The Bank of Canada has set its sights on the loonie, vowing to pull out all the stops if it thinks the rising dollar poses a threat to the fledgling economic recovery north of the border. But with its trendsetting bank rate at just 25 basis points, it would have to look beyond interest rate policy to accomplish that feat.

“Even though we are at the effective lower bound for our policy rate, we retain considerable flexibility through the use of unconventional monetary policy instruments, including quantitative easing [QE],” said Timothy Lane, deputy governor of the Bank of Canada, speaking to the Canadian Association for Business Economics in Kingston, Ont.

It would appear that Lane’s comments had the desired effect: the loonie retreated by more than a cent against the greenback, to 90.98 cents U.S. by early afternoon on Wednesday.

“What are the things that the Bank of Canada could do in an attempt to keep the Canadian dollar in check? [Lane] actually did one of them in his speech, and that is talking about the dollar,” says Peter Drake, vice-president, retirement and economic research, with Fidelity Investments Canada. “The popular term of that is jawboning.”

Drake paraphrases William Lyon Mackenzie King’s infamous comments on conscription: “Quantitative easing if necessary, but not necessarily quantitative easing.”

The policy has been mentioned in the past, but most discussions of its use by any central bank have focused on its use as a last-ditch effort to prime the economic pump.

The bank takes two views on a rising Canadian dollar, depending on whether it is rising because of external pressures, such as U.S. economic policy, or because of internal pressures, which may include rising commodity prices.

“In general, the Bank of Canada has a policy: it doesn’t intervene if the increase is purely an outside consideration,” Drake says. “If you believe any of the analysts who say this might be a pretty modest recovery, then there are reasons to think that the Canadian dollar might not be on fire for all that long.”

Keeping the dollar in check in the short term could help the Canadian economy to capitalize on any growth in the U.S., as it would make our products more attractive.

“If the bank were to do this, it would do it only on the basis that the economic activity was going to be sufficiently weak, that it could do this and not jeopardize its long-term and absolutely sacred goal of keeping inflation under control,” Drake says. “The very fact that the dollar has risen at all is anti-inflationary.

“If the Bank of Canada misjudged, and the inherent strength of the Canadian economy was stronger than it thought, then quantitative easing could be [inflationary]. But I don’t think the Bank of Canada is likely to make that miscalculation.”

Currently, the rate of inflation is under control, rising well below the 2% target, thanks to lower year-over-year energy prices.

Portfolio impact If inflation were to run up, its greatest impact on investor portfolios would be within the fixed income allocation.

“If Canada does embark on a QE program, we certainly wouldn’t be the first. In that sense, it’s not as uneasy a proposition as it would have been a year ago,” says Heather McOuatt, lead manager of the Bissett Bond Fund and Bissett Canadian Short Term Bond Fund.

“I think what [Lane] was trying to do there was use the first line of defence for any central bank, and that’s moral-suasion,” she says. “It’s certainly easier to convince the market that — and I hate to quote [Henry] Paulson here, but — that you have the bazooka to use, rather than actually pulling it out.”

“Supporting or devaluing your currency, as a central bank, is a very difficult proposition. I think they’re betting heavily that the moral-suasion will work.

She points out that the bank has moderated its language regarding the impact that the rising dollar may have on the economy. In June, the bank suggested that currency appreciation could fully offset economic growth, but it is now saying only that the rising dollar could moderate growth.

“The fact that the Canadian economy has seen some improvement might mean that the appreciation of the Canadian dollar, although negative, might not fully offset [growth] as they had said in June,” she says.

In general, QE is seen as an inflationary move and has been described as simply printing money. Inflation is, of course, the enemy of fixed income investing.

“Given the fact that we have a highly accommodative interest rate right now, it tells you that [the bank’s] view on inflation is still very modest in the near term,” says McOuatt. “It’s not a standard policy instrument, so there’s certainly a greater possibility that there could be a policy error—and that would be to the inflationary side.”

If inflation does rear its head much beyond the bank’s 2% target, McOuatt says she would trim the duration on the bonds held in her funds and may employ some inflation-linked notes, if the price was right.

“If they get to the point where they are pricing in an exceptionally high amount of inflation, [inflation-linked notes] might be too expensive to buy as protection against inflation,” she explains. Shortening the overall portfolio’s duration would be an easier play.

Some managers may want to increase their exposure to corporate bonds, as these offer a higher yield than government issues, but McOuatt says her portfolio is already above its usual target for this asset. “Given our current positioning, I don’t think we could do much more.”

Investors seeking a higher return in an inflationary environment may be tempted to increase their equity allocations at the expense of their fixed income holdings, but McOuatt points out that bonds should always be part of a properly diversified portfolio. She suggests that investors move from a general bond portfolio into a shorter-term bond fund, rather than abandoning the asset class altogether.

(08/26/09)