Interest Rate Outlook: Canada

Thanks in part to lower inflation numbers this week, the Bank of Canada is widely expected to lower rates on Tuesday April 22nd. Yesterday, the Core CPI number came in at 1.3%, while Total CPI came in at 1.4%. This CPI number is a reflection of a few large fundamentals playing out in the Canadian market. Let's take a closer look at what those are:

1) Lower trending motor vehicles prices

2) 17.8% drop y/y in fresh vegetable prices, 11.3% drop in prices of fresh fruit y/y, prices for women's clothing down 4.2% y/y (Note: All likely attributed to the stronger Canadian dollar)

3) Higher gas prices

4) Higher mortgage interest cost (New Housing Price Index published last Friday shows a 6.2% y/y increase in new home prices)

Latest CPI Report

Expectations

The lower CPI number gives the BoC some room to maneuver and to take that extra step. Lower rates may also push Canadians to refinance their mortgages which could help to bring down the mortgage interest cost.

I should mention that the stronger Canadian dollar is also having a positive impact on the inflation numbers - rate cuts may jeopardize that going forward. For every 1% that the dollar weakens relative to the U.S. dollar, it costs approximately 1% more to make the same U.S. dollar denominated purchase (oil for example). That being said the market still expects further U.S rate cuts which would offset Canadian cuts in terms of the USD/CAD exchange rate. Although expectations have been scaled back, Fed Funds Futures are still pricing in a 100% chance of a 25bps cut next month.

Unemployment Rate:

I am estimating an 85% chance of a 25-50bps cut. The only reason I am considering a 10% chance of a 75bps move is a remark from BoC governor Mark Carney on April 16th saying that its not unreasonable to talk of 20-30% drop in commodity prices in the future. If he truly considers that to be a serious probability then it implies a CPI level significantly below the banks target. The BoC looks at a target range of 1-3% with 2% being the direct target in core CPI. This months 1.3% could be construed as being too low and therefore a small probability of a more drastic move.

You should also consider that we saw the unemployment rate creep up slightly this month, although still sitting at a fairly comfortable 6.0%.

At the end of the day, I think a 75bps cut would be a huge mistake and its very unlikely to occur. There are a group of economists pushing for a 25bps cut as opposed to the 50bps as they are weary of inflation creeping up and the BoC being forced to rapidly reverse their rate cuts.

Should the BoC choose to cut 25bps, it is likely that we will have to see further rate cuts. A more aggressive approach in a 50bps cut would be the best way to contain CPI in its target range, give a push to the real estate market after 4 consecutive months of slowing building permits and to help out consumers to reduce their mortgage interest costs.

Disclosure: The author has net long exposure to the Canadian Dollar

Comments

[SHB]

"For every 1% that the dollar weakens relative to the U.S. dollar, it costs approximately 1% more to make the same U.S. dollar denominated purchase (oil for example)"

Am I missing something here or is this just stating the obvious?

[Adam Katz]

Thanks for the inquiry SHB. Your comment actually facilitates my intended emphasis which I was trying to achieve by 'stating the obvious'. The point is that the reverse effect has been helping CPI trend lower. Should that unwind, we may see a double whammy. And to reiterate the other side of the argument, further U.S rate cuts should help to offset this and reduce the risk of a strong move in the exchange rate and thus reduce the chances of a sharp spike in CPI (at least in the commodity component).

Thanks for the feedback though. I am a new contributor and any comments on my piece will help make my future contributions an easier read.

Adam Katz