A hawkish hold by the Bank of Canada

Despite the lowest jobless rate since early 2020 and the fastest inflation since the early 1990s, the Bank of Canada (BoC) decided to keep the overnight rate at the effective lower bound of 0.25% in today’s announcement. Moreover, the Bank said it will continue its reinvestment program, through which it will buy Government of Canada (GoC) bonds only to replace maturing securities, thereby keeping its overall holdings at a relatively high level for now.

However, the BoC did take further hawkish steps in the removal of pandemic-era monetary support by ending its exceptional forward guidance on the policy rate, and by preparing markets for the eventual need to raise interest rates. Further, the Bank introduced a potential sequence of events for quantitative tightening (QT). Specifically, 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. Today’s hawkish hold follows the Bank’s previous hawkish move of ending its quantitative easing (QE) program in November 2021.

How are markets reacting?

Despite intensifying pressure from markets, the BoC refrained from using the blunt instrument of rate hikes in lieu of a more surgical, albeit incrementally more hawkish approach.

Markets are rallying in the wake of the BoC’s decision to hold steady, confounding expectations for six rate hikes this year. Recall that the Bank ended QE before the U.S. Federal Reserve (Fed), and Canadian investors got even further ahead of the BoC, so this smacks of a tactical reprieve from overly hawkish sentiment and positioning.

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

Canadian policy rates have remained steady for almost two years, and the BoC hasn’t delivered an interest rate hike since September 2018. However, investors should care less about the precise timing and number of rate hikes, in my view. Rather, I believe they should care more about the general direction of interest rates, which I see changing eventually from flat to up. In other words, I think investors should be positioning for an increasingly tighter monetary regime, if they haven’t started doing so already.

Strategically, would persistent BoC rate increases be good or bad for the Canadian stock market and economy? My sense is Canada generally does best in an environment of robust global growth, rising commodity prices, and an appreciating Canadian dollar – all of which are in place now and are consistent with rate hikes.

What about the Canadian fixed income market? It’s possible the Bank could temporarily engineer a steeper yield curve, given that 2-year GoC bond yields have already increased sharply to about 1.25%. Said differently, four 25 basis-point rate hikes are priced into the short end. Ultimately, however, I’d expect the Canadian curve to resume its flattening trend as the BoC’s tightening cycle fully runs its course.

What are the risks?

Personally, I worry about staking too much on notoriously unreliable expectations for central bank policy rates. If my concerns are valid, it’s possible that Canadian markets might be too hawkish in the face of Canadian gross domestic product (GDP) that remains below pre-pandemic levels.

True, the Canadian unemployment rate has fallen back to a business cycle low of 5.9%, which is noticeably higher than the U.S. jobless rate of 3.9% for structural, idiosyncratic reasons. However, the Canadian economy is growing more slowly (4.0% year-over-year) than its neighbour to the south (4.9% year-over-year), and Canadian inflation of 4.8% is much lower compared to U.S. inflation of 7.0%.

Tactically, the upside risk is Canadian investors are too far ahead of the BoC, which in turn is too far ahead of the Fed’s own tightening cycle. In that scenario, I’d expect GoC bond yields to stabilize or even drift a bit lower, the yield curve to steepen somewhat, and Canadian stocks to enjoy a relief rally from overly hawkish sentiment and positioning.

Looking further ahead, the downside risk is the Bank overdoes its response to inflation and crushes growth. In that case, I’d foresee GoC bond yields melting and Canadian stocks rioting, thereby forcing the BoC into a potentially embarrassing policy about face. After all, it wouldn’t be the first time Canada has diverged too far from the path set by U.S. monetary policymakers.

Finally, excessively high Canadian debt levels are a related risk that should limit the duration and magnitude of the BoC’s tightening cycle, lest it overburdens Canadian households, businesses, and governments with unmanageable debt servicing costs.