Bank of Canada hikes key policy rate again

By: • September 7, 2017 •

The Bank of Canada (“central bank”, “Bank”) has been clear about its intentions to normalize rates and continued to do so by raising the overnight rate by 25 basis points to 1% at its September meeting, following a rate hike in July. The move comes in light of the strong economic growth during the second quarter, expanding by 4.5% on an annualized basis, the strongest growth in six and a half years and the fastest rate in the major developed economies.

Market participants had priced in less than a 50% chance of a hike, partly due to lower expectations of future growth and tame inflation. The sharp move in the Canadian dollar and higher yields across the Canadian yield curve following the announcement reflected the market being caught off guard. However, the central bank has consistently emphasized the need to conduct proactive monetary policy given the lag in the impact of changes in interest rates.

 

Factors Behind the Central Bank's Decision

The hike was supported by the ongoing economic expansion, which is seen as “more broadly based and self-sustaining”, according to the Bank of Canada. Other factors included strong consumer spending, solid job and income growth, as well as improvements in exports and business investment. While inflation is headed in the right direction, it remains below the central bank target of 2% and is the primary factor potentially keeping the central bank from being even more aggressive in its plans to normalize interest rates. The Bank did point out that price and wage pressures are more subdued than normal across all developed market economies.

 

AGF Fixed Income Team's View

We concur with Bank of Canada Governor Stephen Poloz’s efforts to remain ahead of the curve in terms of hiking policy rates, despite pervasively low inflation. Even at 1%, the Bank of Canada’s overnight rate appears too accommodative relative to the strength of the Canadian economy. Indeed, the Bank of Canada stated that the removal of “considerable monetary policy stimulus in place is warranted”, adding the word “considerable” to the current statement, which suggests there are more hikes to follow. We view one more hike this year as plausible, with another one early next year, at which point the central bank may pause to assess the impact of its tightening cycle on the economy. The trajectory of inflation will be critical to the Bank’s future monetary policy decisions.

The Bank of Canada professed little concern over the appreciation of the Canadian dollar, instead pointing to a weakening U.S. dollar against most global currencies. This represents a significant change in the central bank’s rhetoric and suggests a more lenient view on the currency relative to prior years. Consequently, this view reflects a more hawkish central bank that is now dealing with a stronger and more broad-based recovery than in prior years. We believe that the currency has some room to run further, but the Bank may place more attention on the Canadian dollar in the intermediate term as it starts to weigh on economic activity.

In the short term, we believe the Canadian dollar can continue to appreciate modestly relative to the U.S. dollar in light of the strong momentum and tightening interest rate differentials between the two countries. At this juncture, the Canadian dollar also looks relatively attractive against the backdrop of still poor sentiment towards the U.S. dollar and against other developed market countries that have not yet started to contemplate rate hikes.

 

Commentary and data are sourced from Bloomberg and Reuters except where referenced. The commentaries contained herein are provided as a general source of information based on information available as of September 6, 2017 and should not be considered as personal investment advice or an offer or solicitation to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication; however, accuracy cannot be guaranteed. Market conditions may change and the manager accepts no responsibility for individual investment decisions arising from the use of or reliance on the information contained herein.

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Published Date: September 7, 2017