Bank Of Canada Sits Tight, But Expect More Tapering
Cautious Optimism from the BoC
The Bank of Canada has not changed monetary policy, with the overnight rate held at the effective lower bound of ¼ percent and weekly QE asset purchases remaining at $2 billion per week. A move was hardly likely given the recent shock GDP contraction, and the Bank wants to avoid any possibility of being seen taking a view on the Sept. 20 federal election.
The commentary remains cautiously optimistic, though. The negative GDP was caused primarily by supply chain disruptions hitting exports, but the underlying story remains positive. Indeed the BoC “continues to expect the economy to strengthen in the second half of 2021, although the fourth wave of COVID-19 infections and ongoing supply bottlenecks could weigh on the recovery.”
In terms of elevated inflation readings, they are sticking to the “transitory” line for now but acknowledge that “their persistence and magnitude are uncertain and will be monitored closely.”
Canada GDP Surprisingly Fell in Q2
Source: Macrobond, ING
More Tapering Next Month with Rate Hikes in 2022
The case for further QE tapering is strong despite the COVID-19 uncertainty. As elsewhere, supply chain issues, higher energy costs, and re-opening frictions mean inflation is likely to stay elevated for quite some time. With employment levels just 1% lower than February 2020, wage and inflation expectations may push higher, which means annual CPI rates could linger at around 4% for a while, double the BoC’s target.
Vaccination rates are also looking strong, with 67.6% of the population fully vaccinated and an additional 6.3% partially, hopefully limiting the upside for hospitalizations. Consequently, we are hopeful that this will allow the economy to remain largely open even if case numbers continue to rise.
The economy is also receiving ongoing fiscal support with stimulus checks still being paid while 10-year bond yields have fallen 35 bps since May. In an environment where inflation is already above target, and Canada’s booming housing market (prices are up around 25% since the start of the pandemic) is leading to fears surrounding financial stability, there is still a strong case for dialing back the stimulus again on Oct. 27.
We favor QE being reduced to $1 billion per week at that policy meeting and expect the BoC to start raising interest rates late next year with two rate hikes penciled in before the end of 2022.
The Canadian Dollar: Most Negatives in the Price, BoC to Come as a Support Again in October
Although the move was extremely contained, the Canadian dollar had a mildly positive reaction to the recent BoC rate announcement. This is no surprise as the Bank delivered exactly what market consensus was expecting - a pause in tapering while keeping forward guidance unchanged.
We expect the BoC to step in with another reduction in weekly asset purchases by CAD 1 billion in October, which should ultimately offer fresh support to the loonie. Until then, CAD’s recovery will depend on: a) Friday’s jobs data for August; b) the outcome of the Federal election; c) external factors (risk sentiment and oil prices).
We think that August jobs data will not disappoint, which should encourage markets to price in more BoC tapering and offer some respite to CAD, but political uncertainty is set to remain a potential drag as we head into the election.
The polls-imply a probability of a Liberal Party majority government moved from 60% before snap elections were announced to just 2%, according to 338canada.com, as PM Trudeau saw a sharp drop in his approval rating in the past few weeks. According to the latest polls, it now appears marginally more likely that the opposition party (Conservatives) may secure the most votes and possibly form a new coalition government.
For now, markets are concerned about the political picture in Canada, which may stall as parties could struggle to secure coalition deals for some time after the vote.
The Canadian Dollar is Cheap According to our Short-Term Fair Value Model
Source: Refinitiv, ING
We note that the Canadian dollar is trading quite cheaply according to our short term fair value model, which shows a 2.1% overvaluation in USD/CAD (chart above). This mis-valuation appears quite overstretched as it falls above the 1.5 standard-deviation band.
This suggests that most of the negatives are in the price and a dissipation in political risk combined with the Bank of Canada stepping in with more tapering in October may see some idiosyncratic strength emerge. We expect USD/CAD to consistently trade below 1.25 in Q4.
Disclaimer: This publication has been prepared by the Economic and Financial Analysis Division of ING Bank N.V. (“ING”) solely for information purposes without regard to any ...
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