Bank of Canada More Cautious Given Brexit Uncertainty

Key rate unchanged as economic growth downgraded
July 13, 2016 Updated: July 13, 2016

OTTAWA—The Bank of Canada downgraded its economic growth forecasts mainly due to Brexit on July 13, but held its key rate at 0.50 percent as the inflation outlook remains in line with prior expectations.

The U.K.’s decision to leave the European Union creates greater uncertainty in the global economy. The central bank’s analysis takes into account direct trade-type effects. However, it’s much harder to anticipate the implications of the U.K.’s ultimate relationship with Europe.

Bank of Canada Governor Stephen Poloz said the risks around what the new arrangement will look like are “unquantifiable.” It can’t be known how it will affect the outlook for businesses.

“We’re still in the early days of understanding the shock,” Poloz said.

Poloz explained that, post-financial crisis, businesses are now more averse to taking risks and so investment has been slow to recover around the world.

“That uncertainty layer has now been given a reason to extend further,” Poloz said.

Back in June, markets were caught leaning the wrong way expecting the U.K. to remain and a violent repricing in financial markets ensued. But the encouraging sign is that markets handled it well, unlike in September 2008 when Lehman Brothers went bankrupt.

That uncertainty layer has now been given a reason to extend further.
— Stephen Poloz, Governor, Bank of Canada

“There were some big moves. Markets took it well, they were not disrupted, there were no gaps, so I think that’s a good test for how markets can function in the face of something unexpected,” Poloz said. Brexit was like a real live stress test that the global financial system passed.

“You could see some of the benefits of the higher capital and higher liquidity [requirements for banks] that have been put in place across the globe,” said Senior Deputy Governor Carolyn Wilkins.

In its July Monetary Policy Report (MPR), the BoC said the prolonged uncertainty from Brexit “is already weighing on confidence and will likely lead to a postponement of major economic decisions, especially on business investment.”

The good news for Canada is that the BoC expects the impact on gross domestic product (GDP) to be only about -0.1 percent to the end of 2018, reflecting the small amount of trade with the U.K.—a destination for just 3.5 percent of Canadian exports.

Mixed Messages

Brexit has caused financial conditions to become even more accommodative, with near record-low bond yields amid expectations of rate cuts from the Bank of England and the European Central Bank. The Canadian 10-year bond yield closed lower by 0.28 percent on July 13 to 1.01 percent from its pre-Brexit closing level on June 23. Meanwhile, the S&P 500 and Dow hit record highs on July 12 as the TSX hit an 11-month high.

In addressing the apparent mixed messages being sent by stocks and bonds, Aubrey Basdeo, Head of Canadian Fixed Income at Blackrock, tells Epoch Times that bond markets are signalling three truths.

First, they are agnostic to the strength of the U.S. economy. “If risk assets [stocks] have appreciated and yields have not gone up as you would expect, that leads you to think the Fed is not going to react to the [economic] strength anytime soon,” Basdeo says. “Brexit is still an issue for them that they want to see play out.”

We resist the idea of turning 180 degrees on our forecast because of the last few data points.
— Stephen Poloz, Governor, Bank of Canada

Second, the bond market sees the recent U.S. economic strength as transitory, as it has been for the past several years. “We’re not getting all the cylinders firing at the same time; otherwise, growth would be closer to 4 or 5 percent, not 1 or 2,” Basdeo says.

Third, “every basis point counts,” Basdeo says. A basis point is one one-hundredth of a percent. “There’s a search for yield like we’ve never seen before.” About a third of the developed world’s sovereign bond markets have negative yields, so as investors buy bonds with positive yields, the prices of those bonds rise and the yields then fall.

On the Sidelines

Oil prices have stabilized recently around a level US$10 higher than at the time of April’s MPR, as supply and demand are relatively in balance. The BoC expects the U.S. energy sector investment to recover accordingly.

Due largely to the Alberta wildfires, the economy is expected to have contracted by around 1 percent in the second quarter. But the BoC expects Q3 growth to rebound to 3.5 percent as the rebuilding efforts in Fort McMurray take shape, oil production resumes, and U.S. demand picks up. There is also reason to be patient as the federal government’s fiscal spending will only start to have an impact in the second half of 2016.

The GDP growth projection for 2016 was marked down from 1.7 percent in the April MPR to 1.3 percent in July’s MPR. For 2017, the projection falls from 2.3 percent to 2.2 percent. The BoC’s global growth projections were shaved by 0.1 percent in 2016 and 2017 to 2.9 and 3.3 percent respectively.

Business investment is one of the culprits for the expected lower growth. Weak business investment is a 0.9 percent hit to GDP in 2016, according to the BoC. The investment share of the energy sector has fallen from about 4.0 percent of GDP in 2014 to an estimate of about 1.5 percent for 2016 to 2018.

The growth outlook is also hampered by volatile and recently weak exports. Non-energy exports have fallen in three of the last four months—and Brexit is expected to further reduce foreign demand.

“We resist the idea of turning 180 degrees on our forecast because of the last few data points. The proof will be in the longer-term data,” Poloz said.

Despite the downgrade to economic growth projections, the BoC expects inflation to return to the 2 percent target in 2017 due to higher oil prices.

“The key takeaway here is that it will take another very significant disappointment in the economy to get them to shift to an outright easing bias, let alone to cut further,” said BMO Chief Economist Douglas Porter in a note. Porter sees the BoC on hold well into 2017.

RBC Deputy Chief Economist Dawn Desjardins shares a similar view.

“The Bank incorporated a lot of bad news into the July update and still deems the risks to the inflation outlook as roughly balanced.  This means that conditions, largely outside their control, would need to deteriorate further before they would cut again,” Desjardins stated in a note.  

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Follow Rahul on Twitter: @RV_ETBiz