Daily Forex Fundamentals | Written by TD Bank Financial Group | Jul 11 08 21:04 GMT |
The market has undergone a profound shift in expectations since the June 10th Bank of Canada Fixed Announcement Date. Though the decision to keep rates on hold at 3% surprised the markets, the accompanying statement indicated that the bias is now neutral. Subsequent comments by Governor Carney reinforced that view very clearly when he stated that “going forward, there remain important downside and upside risks to inflation, but these risks are now judged to be evenly balanced.”
With a clear neutral bias, market expectations have shifted accordingly. It is now clear that the Bank is comfortable with the overnight rate at 3%, but it will be keeping a close watch on inflation. On that front, there is some cause for concern. Nonetheless, a careful assessment of both economic conditions and Bank rhetoric prompt us to think that the Bank will take an opportunity for a breather on the sidelines leaving rates at 3% on July 15. Down the road, the Bank will be compelled to begin a tightening cycle in 2009.
Slower Economic Growth Will Tame Inflation
The economic data have shown signs of modest improvement after a dismal first quarter in which the Canadian economy contracted by 0.3% (q/q, annualized), due primarily to weakness in inventories and residential structures.
In April, GDP posted a robust 0.4% M/M gain, which made a nice kick off to the second quarter. The domestic side of the economy is holding up reasonably well, thanks to the income gains derived in large part from the commodity boom. In Governor Carney's Calgary address, he noted that “since 2002, rising commodity prices have fuelled a 25% improvement in our terms of trade, which alone has been responsible for roughly two-thirds of the 15 per cent gain in real per capita disposable income.” Such income gains have supported retailing activity, which is still up over 4% on a year ago basis. The real question is how the slowdown in the U.S. will impact Canada's export sector. And on that front, the storm clouds remain ominous and suggest trade will continue to be a net drag on GDP until early 2009. This means the Canadian economy should remain weak and we expect growth of 1.9% in Q3 and just 0.8% in Q4.
A slowing Canadian economy means the output gap, which is now closed, may move moderately into excess supply in the summer months. That will take some of the pressure off inflation, which reduces the need for any immediate rate increases. As such, the best recipe in this situation is to stay on the sidelines.
Inflation is Percolating
While not an immediate problem, inflation risks are turning more problematic. Thus, there is scope for keeping rates on hold now, but keeping a watchful eye on inflation going forward. Canadian core CPI remained well contained at just 1.5% Y/Y in May and has not crossed the 2% threshold which is the Bank of Canada's operational target since September 2007. However, core CPI on a three month annualized trend was 2.2% in May, and several other alternative core measures also point to inflation a little above the 2% target.
Further up the pipeline, wage pressures remain strong, and are trending well above historical averages. In May, the average hourly wages of permanent employees rose 4.6% Y/Y as a still tight labour market allowed workers to bid wages higher. Unit labor costs, or wages adjusted for productivity, have been on the rise since mid-2007 and are now nearly 4% on a year ago basis. But the likelihood of a true wage-price spiral seems small, and the risk that workers will try to negotiate higher wages to offset the erosion of purchasing power is unlikely to be as big of a threat as commodity prices. On the flip-side, capacity utilization measures have recently plummeted, and a recent change in the mortgage industry could crimp home inflation. Moreover, growing economic slack should keep the reins on inflation.
In addition, expectations for headline inflation have been creeping higher, which is no doubt concerning to the Bank. In the Bank of Canada's Summer Business Outlook Survey 35.6% of the respondents expected inflation to be above 3%, which is the highest level since the survey began. Expectations for higher prices along the production chain suggest that inflation is becoming well entrenched. Not only do businesses expect higher input prices, but they also expect to pass on those higher prices by raising output prices. Note however, that the Bank of Canada would have had a peek at this information going into the last meeting and so the neutral bias already reflects this view.
Headline inflation, however, is already a little too hot. Rising food and energy prices have pushed inflation back above the 2% rate. In May, all-items CPI was up 2.2% Y/Y. Looking ahead, inflation appears to be on an upward trend. Since the June 10th FAD, a barrel of crude oil has gained nearly $15/barrel to trade at a new all-time high of $145.29. Oil is just one of many commodities that continue to post strong gains. The Bank of Canada's commodity price index is up 48% Y/Y in June and the energy sub component is up a whopping 89% Y/Y. The steady rise in oil prices will surely push headline inflation higher in the near term.
Other commodities such as food are also poised to push headline inflation higher for a number of reasons. First, the trend appreciation in the Canadian dollar was an important factor in pushing prices lower in 2007. The media attention on the issue was an important catalyst for the downward pressure on prices. That now appears to be over. Since the beginning of the year, the loonie has stabilized around parity with the U.S. dollar, and going forward, we expect the Canadian dollar to give up some ground against the U.S. dollar. As such, the currency is no longer playing a prominent role in holding down prices and retailers are under less scrutiny to keep prices low.
Secondly, in the past couple years, food prices have been contained by the intensifying competition between Canadian grocers trying to preserve their market share, as companies like Wal-Mart are trying move into Canada. This is likely a one-time effect which is unlikely to be repeated.
Third, because of the way the Canadian CPI is constructed, food prices play a more prominent role not only in headline CPI, which includes 17% food (as compared to 13.8% in the U.S. definition), but also there are some food items like bread and meat which are included in the core CPI definition. Thus, with expected increases in food prices in the near term, there may be some follow through to headline and core inflation readings. All told, we forecast Canadian CPI to breach the 3% threshold by year end, while core should hit 2%.
The disconnect between headline and core CPI poses something of a dilemma for the Bank of Canada. The Bank of Canada normally uses core inflation as its operational guide. But the forces pushing headline inflation, particularly commodity prices, cannot be completely ignored. When Governor Carney addressed an audience in Calgary shortly after the last meeting, he acknowledged that, “the Bank needs to be mindful of the possibility that rising commodity prices may affect the relationship between total and core CPI” and added that “the Bank will also continue to look at a range of measures to assess the underlying trend of inflation.” However, the Bank has also reiterated its focus on core CPI recently, and we do not expect any sharp changes in methodology in the near term.
Credit Conditions Still on the Mend
Also arguing for steady rates in the near term is that the impact that the credit crunch has had on the Canadian economy.
The three month CDOR versus the three month OIS spread narrowed to 27 basis points over the past few months, and is well below the highs recorded last August when the credit crunch first hit or during the Bear Stearns bailout. In fact, the narrowing in the three month CDOR-OIS spread has been sufficient enough to cause the Bank of Canada to discontinue its Term PRA program of liquidity injections because “conditions in Canadian markets have improved since the end of April.”
Other positive signs of improvement in the credit market stem from the recent Business Outlook Survey. The response to the question on credit conditions indicated that although conditions have continued to deteriorate since April, the pace of weakening has slowed.
But while there has been measurable improvement in Canadian credit conditions, they are still not back to historical trends. All this suggests the need for some further repair. As such, a rate hike at this point would be far too early and disrupt the ongoing repair in credit markets.
What Will the Bank Say?
Given that the market is pricing in steady rates, the focus will be on the accompanying statement. A great deal of attention will be paid to any revisions the Bank will make to the economic forecasts. These revisions generally only occur in every second rate decision because it is when the MPR is released. This next decision is one such opportunity. In the last MPR, the Bank forecast H2 inflation of 1.9% Y/Y and core inflation of 1.5% Y/Y. There could be upward revisions to those figures and the full details will be released on Thursday with the Monetary Policy Report Update. Note, however, that the BoC's surprise pause in June was almost certainly backed by an internally revised economic and inflation forecast. Since very little time has passed since the last decision, it is unlikely that a revised forecast will translate into a substantially revised bias for the future.
We expect that the statement will stick to the broad outline set out in the last statement, and still maintain a generally neutral bias. As such, the statement “the Bank now judges that the current stance of monetary policy is appropriately accommodative” is likely to remain a fixture in the communiqué, in addition to a statement that the risks remain balanced. Outlook for Rates
There are a number of upside inflation risks that argue for higher rates going forward, but some of the froth on inflation will come off as the Canadian economy begins to cool. That suggests there is a window of opportunity for the Bank to assess what is happening with inflation trends in Canada. Consequently, we expect the Bank has now entered a protracted period of sitting on the sidelines and will not entertain serious thoughts of hiking rates until H2 2009. By that time, the Canadian economy will have gone through the storm and will be sufficiently strong to withstand higher rates.
TD Bank Financial Group
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