Global Central Bank Focus

Canada’s Monetary Policy Stuck Between a Rock and a Hard Place

Understanding a central bank’s reaction function to volatile financial and commodity markets can help investors navigate an uncertain environment.

Canadian investors today may feel anxious as they look at the country’s core and headline inflation rates hovering around 2% while economic growth faces headwinds and sovereign bond yields remain low. What is the outlook for Canada’s economy and investors, and how will policy (monetary and fiscal) along with oil prices shape that outlook over time?

PIMCO describes the global secular economic environment of overhanging debt, lower growth and lower neutral interest rates as The New Neutral. In Canada, it means the neutral overnight policy rate will be closer to 2%–3% than the pre-crisis neutral rate of approximately 4%. While we believe this will be the secular journey of the Canadian bond market, tremendous economic and market uncertainties complicate that journey. For investors to successfully navigate the years ahead, it helps to understand the reaction function of policymakers to volatile financial and commodity markets.

The rock (rock-bottom interest rates)

Here’s a crucial question: Have central banks hit the limits of monetary policy effectiveness, especially now as more and more bonds yield a negative interest rate? At PIMCO, while we think policy effectiveness has diminished, we believe lower positive rates still are likely to have some ability to stimulate economic growth. Negative rates are another story: The recent decision by the Bank of Japan to move to negative rates led the Nikkei stock market to drop and the yen to rally – the opposite of the intended outcome.

While the Bank of Canada (BoC) prudently cut the overnight rate by 0.50% in response to the oil price plunge last year, it realizes that this has reduced the cushion between it and the other central banks who are engaged in non-traditional monetary policy. As a Canadian bond investor, we have to realize the reaction function of the BoC not only to Canadian growth and inflation, but also to global financial conditions and the policies of other major central banks. We believe that the BoC would like to avoid joining the Bank of Japan, the European Central Bank and other central banks engaged in nontraditional monetary policies that could have unintended negative consequences.

The hard place (energy markets)

In addition to unprecedented monetary policy in many parts of the world, Canadians also have to deal with the oil market. Western Canadian Select (WCS) oil prices declined approximately 85% from June 2014 to February 2016 (according to Bloomberg), an incredible shock to Canada’s energy sector. And just to make things interesting, WCS bounced 105% from the low in February 2016 to the high price 40 days later. Talk about volatility! No wonder oil company executives have little confidence to invest in capital expenditures and are waiting for some semblance of rational market pricing before making significant investments.

Oil and other commodities are critical to the Canadian economic outlook. PIMCO’s dedicated commodity portfolio managers contribute their views at our regular Canada Forum, where we debate the state of the economy and markets and look to identify the trends that have important investment implications. Following the most recent forum, we expect WCS oil prices to rise by about $10–$15 per barrel in 2016, which should reduce oil’s headwind to Canadian economic growth.

Fiscal policy to the rescue?

We give Canada’s federal government credit for recognizing that the BoC is nearing the limits of traditional monetary policy, and engaging in fiscal stimulus. Our estimate is that the federal government fiscal stimulus will add approximately 0.2%–0.3% to real GDP growth by the end of 2016 and 0.3%–0.4% in 2017. After years of relying on monetary policy to lift growth, investors now look to the federal government to provide the bridge to more sustainable economic growth. To be clear, it is only a bridge, and Canada needs Ontario and Quebec to start generating growth in non-energy sectors. As the U.S. economy continues to recover, Canada needs non-commodity exports to generate growth. Housing continues to be a risk to the economy, but with historically low interest rates and unemployment near its long-term average of around 7%, we do not forecast housing to be a headwind to Canadian growth in 2016. We applaud federal policymakers for continuing to implement rules that gradually tighten mortgage credit expansion, and there is more that needs to be done, but a gradual approach is wise (as an abrupt tightening of mortgage credit may cause what policymakers are trying to avoid: a housing crash).

Investment implications

We think Canadian real GDP will grow this year at 1.25%–1.75% while core inflation hovers around 1.75%–2.25%. We expect growth to be led by Ontario, Quebec and British Columbia as non-energy sectors benefit from a lower Canadian dollar.

In this environment, we see value in real return bonds with breakeven inflation at 1.6% (well below our core inflation forecast). We also see value in high quality and relatively liquid sectors of the Canadian credit markets. Provincial bonds and high quality corporate bonds such as bank deposit notes are some areas where we find attractive opportunities. With federal government 10-year bonds offering paltry yields of around 1.5%, we suggest investors consider doubling the portfolio yield potential by moving into other sectors of the bond market.

The Author

Ed Devlin

Head of Canadian Portfolio Management

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