The Bank of Canada held its key interest rate steady at 5%, but left the door open for further hikes amid worries over persistent inflation. Anthony Okolie speaks with Sam Chai, Vice President, Active Fixed Income Portfolio Management, TD Asset Management, about the latest decision and the outlook for rates going forward.
* As expected, the Bank of Canada held its key overnight rate steady at 5%. Sam, did anything stand out for you today?
* So I'd say that, given the incoming data we have seen and considering the market development we have seen since the last Bank of Canada meeting, I'd say today's outcome is not as surprising for us. In fact, both us and the market had been expecting a hawkish hold from Bank of Canada for this meeting. And they had kept the policy rates unchanged, and also kept a tightening bias in their forward guidance.
* Why have we arrived at this conclusion? So if you look at the revised economic data, you will see that back in July, the Bank of Canada had forecasted in the second quarter that there will be an economic expansion of around 1.5% for the second quarter. But the actual realized data is a negative 0.2% contraction. So--
* So it's actually come down below their expectations.
* For sure. It's a very meaningful downside surprise. And when you look at the Q3 business outlook survey, it's also showing that consumer spending and business sentiment have weakened meaningfully. And so we are unlikely to see a rebound in the Q3 GDP, as well, from Q2.
* Moving on to the inflation side of things, the September CPI data had also been a very encouraging surprise, downside surprise. Three-month annualized core inflation trim, a measure that Bank of Canada looks at very closely, had fallen from 4% to the 3.5% to 4% range. And month-over-month, the September core inflation increase is actually the smallest in over a year. So very encouraging.
* On the other hand, inflation expectation data, as measured by the business outlook survey, had also moderated slightly from the prior quarter. So again, lowering the right tail risk for inflation. So all those factors contributed to the Bank of Canada feeling comfortable enough to hold rates steady in this meeting.
* In terms of market reactions, generally a pretty orderly response to the Bank of Canada outcome. The Canadian curve has just generally steepened somewhat.
* OK, so given that economic backdrop, do you think that the Bank of Canada is done rate hikes for this year?
* Yeah. So our current base case scenario is that we see Bank of Canada holding rates steady for the remainder of this year, but our risk case being that we see a further acceleration in inflation and the Bank of Canada may need to tighten a bit more. So let me just, like, talk about it in a bit more detail.
* So in general, considering forward-looking economic indicators, for example, job vacancy rate that has fell meaningfully over the past months, these indicators are showing further moderation in economic activities, a further slowdown in labor market, which should translate to reduced upward inflation pressures. Indeed, Bank of Canada also acknowledged that, given the highly restrictive policy rate we currently have, it has significantly weighed on demand already. And so with that, we expect that Bank of Canada will hold rates unchanged over the remainder of this year.
* That being said, there are definitely risk factors. When you consider the three-month annualized core inflation metrics, despite a positive print in September, over the past months, this metric had hold around 3.5% to 4% for already several months.
* And when you also consider that the hourly wage growth in Canada for several months had been above 5% consistently, these are indicating that these are inconsistent with the Bank of Canada's 2% inflation target still. So if these pressures persist, or even worsen, that may incentivize Bank of Canada to tighten policy a bit more.
* OK. And what is the bond market telling us right now, in terms of further Bank of Canada moves in their overnight rate?
* So the market pricing for Bank of Canada right now is roughly a 20% chance of another hike in December. And then for the majority of next year, we should be on hold until one cut being fully priced by the fourth quarter next year. And then this is followed by three additional cuts in 2024.
* And when you compare this to our neighbor down in the south, you'll see that the Fed is priced for a cut in the third quarter of next year, followed quickly by two additional cuts for the remainder of next year. So in a nutshell, our neighbor is expected to cut both more aggressively and faster than us, though personally I think it is still debatable whether the Fed will ease that much more aggressively than the Bank of Canada.
* That's a great comparison. Looking ahead, what are some of the key indicators that you'll be watching as the Bank of Canada considers its next move?
* I'm happy to say that Bank of Canada has been very clear in terms of what they're watching to arrive at their decisions. In particular, there are a few broad categories. The first one is economic activity data slash level of excess demand. The second one is inflation and inflation expectations.
* The third is labor market and wage data. And the last one is just corporate pricing behaviors. We haven't had a chance to listen to Governor Macklem's conference yet, but I look forward to see if he'll shed any additional light in terms of the latest policy reaction function.
* OK. And finally, where do you see the Canadian dollar going over the next little while?
* So I see that, given US relative economic outperformance, as well as generally deteriorating risk sentiment that we have seen over the past weeks, dollar/CAD had been rising steadily over the past weeks. That being said, year-to-date, the pair had been within a range of 1.3% to 1.4%, given tight monetary policy correlations. I expect that this range should continue to hold.
* So there could be interesting tactical opportunities if the pair reaches either side of the range. That being said, considering our expectation that the data momentum likely is going to continue to slow down in the coming months, and considering tail risk, including the geopolitical risks we are currently seeing in the market, holding dollar exposure still provides good diversification benefit to one's portfolio.
* Sam, thanks very much for joining us.
* Thanks for having me today.