NAFTA Concerns Not Likely to Stop Bank of Canada
Despite a flare up in trade relations last week, markets expect the Bank of Canada to raise the overnight rate at its first meeting in 2018 tomorrow. Bloomberg reports that the odds of a hike have rebounded to 92%, based on overnight index swaps. Bloomberg added that 26 of 27 economists surveyed expected a hike. Reuters reported lower odds at 77% but still in favor of a hike.
We side with the consensus. We don’t believe concerns about NAFTA negotiations will be sufficient to keep the Bank of Canada in its cautious posture. Our preferred measure for gauging the strength of incoming economic data is Citigroup’s economic data change index. This measures economic data relative to 1-year averages. We highlighted in November that the Canadian economy was weakening rapidly as the Bank of Canada hiked the overnight rate at two consecutive meetings on July 12 and September 6. Canada was the first major developed market economy to see economic growth fall below 1-year averages. But things have changed since November.
The chart below shows the economic data change index rebounded smartly since its October 31 low. Outperformance versus 1-year averages is now greater than it was at the September hike and very near where it was when the Bank of Canada first followed the Fed is raising rates.
The Bloomberg article highlighted rising 1-week implied volatility for USDCAD, but longer implied volatility measures aren’t showing the same concern. The chart below shows the Canadian dollar and 1 month implied volatility are both very near where they were for the past two rate hikes. Neither shows signs of significant stress about trade negotiations.
The next chart shows the Goldman Sachs financial conditions index for Canada. Financial conditions are easier now than they were at either of the two rate hikes from 2017.
And the last chart shows that the S&P TSX Composite has rallied 7.8% since the Bank of Canada hiked rates in September. Canadian equities didn’t blink when the blowout December employment report sent the odds of a rate hike over 90%. It has shrugged off last week’s concerns about NAFTA and odds that still favor another hike in the overnight rate.
The one concern we would expect the Bank of Canada to be monitoring is the shape of the yield curve. While the 2y10y spread has steepened just over 10 bps since dipping below 30 bps, it remains perilously close to inversion. And the 5y30y spread has yet to see a meaningful rebound. Dampened inflation expectations and a hawkish stance from the Bank of Canada have kept long end rates anchored even as shorter rates pushed higher.
Markets expect that the Bank of Canada will kick the new year off with a bang. After a blowout employment report in December accelerated a broader rebound in economic data, conditions are in place for the Bank of Canada to step out of its cautious stance. One potential warning sign is the yield curve. The Bank of Canada may not have much room to continue tightening, but we believe they will take the opportunity to strike when the iron is hot. We expect them to acknowledge the lingering uncertainty but press ahead with their plan to continue tightening policy.