Bank of Canada: We have liftoff

by Talley Léger, Invesco Canada

In response to hot inflation and high commodity prices, the Bank of Canada decided to raise its key rate by 25 basis points today – the first increase since 2018. Talley Léger shares the market reaction, potential risks, and why it’s important to investors.

In response to hot inflation and high commodity prices, the Bank of Canada (BoC) decided to raise the overnight lending rate from the effective lower bound of 0.25% to 0.5% today. However, the BoC acknowledged heightened geopolitical uncertainty and said it will continue its reinvestment program, through which it will keep buying Government of Canada (GoC) bonds only to replace maturing securities, thereby keeping its overall holdings at a relatively high level for now.

Looking ahead, the Bank did take further hawkish steps in the removal of pandemic-era monetary support by preparing markets for the eventual need for quantitative tightening (QT). As a complement to interest rate hikes, the Canadian authorities will now consider exiting their reinvestment program by allowing the BoC’s bond holdings to mature, thereby reducing the balance sheet from its current high level.

How have markets reacted?

The Canadian dollar and stock market are rallying in the immediate aftermath of the BoC’s first interest rate increase since September 2018. Meanwhile, GoC bonds are selling off and the yield curve is flattening – a trend I expect to continue as the BoC’s tightening cycle fully runs its course. For the bear flattener to potentially morph into a bull flattener, I suspect moderating output, easing supply chain disruptions, and cooling inflation would be required.

What are the risks?

I wouldn’t want to be a policymaker in this environment of heightened geopolitical uncertainty and related energy supply shocks. If a central bank overreacts to inflationary pressures, it could restrict financial conditions, negatively impact confidence, and potentially drag down economic growth. If the monetary response is understated, it could exacerbate inflationary pressures as well as their destabilizing effect on consumption and the pace of broader economic activity.

To use a golfing metaphor, however, it seems the BoC kept it in the middle of the fairway. On one hand, Canadian policymakers gave just enough of a signal — a 25 bps hike, but not a 50 bps hike — to convey that the general direction of interest rates is changing from flat to up. On the other hand, the BoC stopped short of QT and refrained from allowing its GoC bond holdings to begin shrinking.

Why is it important to investors? What are the investment conclusions?

At the very least, I think the Canadian stock market and energy sector are interesting geopolitical hedges in this tense operating climate.

Generally speaking, my sense is that Canada does best in an environment of robust global growth, rising commodity prices, an appreciating Canadian dollar, and higher interest rates — all of which are in place now.

The following chart shows that Canadian stocks tend to do better when commodities are rising (one form of inflation), as has been the case since early 2020. While Canada is a developed country, it relies on resource extraction so firming raw materials prices have been an important link in a chain of positive events for Canada. Simply put, I believe that what’s good for materials prices is generally good for the Canadian economy.

Early-stage commodities (dark blue) and Canadian stocks (light blue) since 2000

The bottom line is that economic growth, early-stage commodity prices (as measured by the CRB Raw Industrials Index), the loonie, and Canadian stocks have typically moved in the same direction across time. All those asset classes are “first movers” and are extremely sensitive to minute changes in the North American economic outlook, which remains relatively stable for now.

This post was first published at the official blog of Invesco Canada.