Bank of Canada: As expected, Poloz still the Number Two hawk

More important than the actual rate move is Poloz’s signaling, especially given NAFTA’s recent reconfiguration into the U.S.-Mexico-Canada Agreement (USMCA) and October’s generalized stock market malaise.

With the NAFTA overhang quasi-resolved, and the realization out west that shipping LNG to East Asia is not only politically palpable but a matter of national security, Poloz and the Canadian public finally have some good economic news in what has been a tough year for the country.

For an idea of the BoC’s relative position, consider the actions taken (or not taken) by several other major central banks of late. After hiking to 0.75% in August, the Bank of England appears to have its hands tied. It is hard to see how the Brits can make any moves between now and March 2019, the deadline for the to-be-determined “soft” or “hard” Brexit. Even if Brexit goes well, the BoE would seemingly need to take a cautious approach next spring and summer, meaning GBP rates will likely be a full 100 bps or more south of CAD’s throughout 2019.

The European Central Bank is also in no hurry to do much regarding interest rates. Given the VIX’s recent spike to 23¹amid China slowdown fears and Italian budget risk, any forecasts of a one-off rate hike by the ECB next year must be called into question. That is truer now than at any time in the last year or so, as Italian bonds maturing in 10 years have gapped up to 3.60%, a striking 320 bps spread over 10-year German bunds (0.40%).

The fear in southern Europe is of a “doom loop.” In this scenario, Italian banks, which are heavy owners of Italy’s sovereign debt, see the country’s yields rise, which weakens the banks’ capital base. That, in turn, sends government bond rates higher. A dog chasing its tail.

Of interest to the BoC, the Toronto housing market has somehow managed to pull off the sweet-spot slowdown, at least for now. This has surprised us, given the rarity of asymptotic price surges giving way to post-peak gentle, sideways slopes. The Teranet National Home Price Index for Toronto has managed to curve ever so slightly downward since summer 2017, witnessing total price depreciation of just 3.8% from the peak to September 2018.

If Street consensus is correct, the BoC will bring the policy rate to 2.25% or 2.50% at the end of 2019. There are some observers out there with calls for 2.75% or 2.00% on both sides of the bell curve. In order to have the confidence to hike three or four times, Poloz will want to see GTA home prices continue to click sideways with each of the Toronto Real Estate Board’s monthly reports. And that means no big swoons in activity like in Vancouver, where buyers and sellers are engaged in a staring contest that is becoming disconcerting.

Aggressive BoC rhetoric

In the Monetary Policy Report, the central bank went heavy on USMCA references, opening with the trade deal and then coming back to it again just a couple of paragraphs later. They were keen to make mention of British Columbia’s natural gas pipeline announcement as a one-two punch for justifying a confident onslaught of 2% on the overnight rate.

We are focusing less on the BoC’s forecast of around 2% CPI inflation from now to 2020 and more on the bank’s assertion that the economy is operating “at capacity.” This is critical. The U.S. still has some room to challenge its capacity utilization precedent, set just short of 80 on the eve of the 2015–2016 China scare. But for all intents and purposes, American capacity utilization at 78 is a rounding error compared to its limit (the 80 area).

If Poloz believes Canada is “at capacity,” and it looks to us like the U.S. is there too, then this is the stuff of inflation scares. Of the forecasting outliers (those penciling in 2.0% or 2.75% for year-end 2019), we think the latter camp has a better chance of being proven correct, on account of our thesis that the global trade war concept is overblown and “priced in.”

Items to watch, next 6 to 12 months

While we would be foolish to not focus on “classic” central banking metrics such as inflation and employment a few other idiosyncratic issues are also critical:

• Whether what has now grown to a 43.5% yearly fall in Vancouver residential property sales is the beginning of something more sinister.No doubt, Vancouver’s prices are still showing yearly price gains, but the market is on shakier ground now than in 2017. If Vancouver stays soft, eyes will no doubt be focused on the GTA’s housing market too. It is still early days in the implementation of the provinces’ home purchase taxes. There is also the very real possibility that any moment could bring a crackdown by Beijing on capital flight, hitting Canada’s two most speculative cities.

• The sustainability of the striking gap between Western Canada Select and Brent Crude oil.We suspect that, at some point, some junior aide with a Bloomberg terminal will whisper in President Trump’s ear that Canadian crude oil is on the auction block for $22 per barrel. If the Trump administration chooses to pull a power play on the Saudis for the Khashoggi murder, a smile northward and some friendly overtures to Ottawa from Washington could pleasantly reverberate across boardrooms in frustrated Calgary. A rally there could give policy hawks the confidence to stay the course in calling for an aggressive Stephen Poloz in 2019.

• The path of the U.S. Federal Reserve.Many on the Street anticipate that the U.S. central bank will hike rates another 25 bps at its December meeting, while in some policy circles, there are calls for as many as four more during 2019. A low-to-mid 3% Federal Funds rate, if it should play out that way, would seemingly also provide Poloz the incentive to end 2019 on the more hawkish side of current consensus (BoC closer to the 2.50%–2.75% range than 2.00%–2.25%), in the interest of loonie stability relative to its largest trade partner.

With respect to CAD’s $0.77 exchange rate with USD, we do not see any material reason to move away from a neutral view. However, European currencies, particularly GBP and EUR, are vulnerable, here given both the BoC’s actions and words.

Poloz and Powell are holding hands as the only two hawks on the block, and we cannot find any major economies in the industrialized world that are ready or willing to follow suit.

¹All market data in this report is Bloomberg, as of 10/24/18.

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