It’s fair to say that the Bank of Canada (BoC) is typically considered less globally significant than many of its G7 peers; however, we think global investors should take a closer look at the statement that accompanied the announcement, because we strongly suspect that the bank’s thinking was heavily influenced by Tuesday’s conference call with G7 finance ministers and central banks.
Crucially, we believe the statement that accompanied the BoC’s announcement provides important insight into how global central banks are approaching the coming economic shock. Here are our takeaways from the BoC’s statement and why we think they matter to the global central banking story.
Globally coordinated rate cuts are here, central banks are working together
The G7 finance ministers and central banks conferred on Tuesday, then issued a statement that—to investors’ surprise—didn’t include any specific policy action. For two brief hours, it appeared as though a coordinated response by global central banks wasn’t going to materialize. At that point, it seemed investors would have to wait and see how the various central banks would respond to the challenge brought on by the coronavirus outbreak individually. Then, out of the blue, came the U.S. Feral Reserve’s (Fed’s) 50 basis points (bps) rate cut announcement.
On one hand, this made sense: The Fed is essentially the central banker to the world—arguably the only one with enough clout to single-handedly calm financial markets and ease global financial conditions. But on the other hand, the Fed’s (lone) announcement on Tuesday, which followed an odd sequence of events, suggested that the rest of the G7 central banks were not on board.
Then came Wednesday, and enter the Bank of Canada, which, just like the Fed, dramatically cut interest rates by half a percentage point (we would argue that it could have gotten away with a 25bps cut). Our attention was immediately drawn to the last sentence in the BoC’s statement, which clearly spelled out a narrative of cooperation: “The Bank continues to closely monitor economic and financial conditions, in coordination with other G7 central banks and fiscal authorities.”1 Where we’re concerned, the message is clear—while we didn’t get a coordinated interest-rate cut that was announced simultaneously on Tuesday, global central banks are in the midst of unleashing coordinated stimulus on a significant scale.
The BoC’s statement also strengthened our belief that additional easing of similar magnitudes will be coming from the European Central Bank (ECB) on March 12, the Bank of Japan on March 19, and the Bank of England (BoE) on March 26 (although they could come in different forms, using different tools). We’re also leaning toward another interest-rate cut from the Fed when it next meets on March 18, and we expect other major central banks to follow suit; some, such as the Reserve Bank of Australia, have already done so.
It’s the demand shock that’s worrisome
In our view, the most important line in the BoC’s statement was one that emphasized the demand-side shock emanating from the COVID-19 outbreak: “It is likely that as the virus spreads, business and consumer confidence will deteriorate, further depressing activity.”¹ We strongly suspect that central banks are far more concerned about a confidence shock than they are about a supply-side shock. While another bout of deterioration in manufacturing and global trade will no doubt be painful, they’re much easier to measure and forecast than a confidence shock. In addition, supply-side shocks are more easily recouped; for example, if a car didn’t make it onto the production line in February, the factory can go on overtime and make up for the lost production by producing two cars in June. We can’t say the same of demand-side shocks: Opting to skip a dinner and movie in February doesn’t necessarily mean you’ll make up for it by going out twice in June.
As we’ve mentioned in our previous publications, while rate cuts won’t ease fears about personal safety, they can reduce the debt burden on households and businesses. This is important because it means this can place extra money into the consumers’ pockets and reduce debt bills so that defaults are less likely.
That said, we continue to emphasize that while the market may be able to look through a growth scare or recession triggered by a supply shock, it’s likely to act differently if households and businesses were to pull back from spending in a significant manner. It seems the BoC also shares that concern.
The divide between fiscal and monetary policy is disappearing
The BoC referred to “fiscal authorities” in its statement,¹ implicitly tying the two policy tools together. References to coordination between central banks and governments—an idea that would have been considered quite taboo even a year ago—are popping up much more frequently. For example, the incoming BoE Governor Andrew Bailey said on Wednesday that the bank would be working hand in hand with the U.K. Treasury to support growth.2
Just as we expect rate cuts from every major central bank, we also expect every major G7 economy to ramp up government spending in the coming month. For example, Canada’s federal budget is due in three weeks, and we expect it to include tools to support public health infrastructure, households, and businesses. But as usual, it will be the fine print that will matter the most—will government spending enter the economy quickly enough and flow to the areas where it’s most needed? The magnitude of this (expected) coordinated fiscal drive will have a material impact on growth forecasts, particularly in 2021, and to the steepness of the yield curve.
More rate cuts are coming—from everyone
Having spent years trying to decipher central bank speak, we’re convinced that the BoC’s statement tells us that more rate cuts are on the table: “Governing Council stands ready to adjust monetary policy further.”¹ We expect the bank to lower rates by at least another 25bps at their April meeting.
However, we continue to be concerned that market expectations could be overly aggressive, creating scope to be disappointed with less easing than expected, as opposed to more rate cuts than what’s already been priced. As of this writing, the market expects the Fed to slash rates by at least another 75bps. Expectations for Canada are slightly less aggressive by comparison, have only priced in another 50bps rate cut.³ In other words, at this point, the BoC is less likely to disappoint than the Fed.
Central banks are quietly concerned about liquidity
Here’s a line from the BoC’s statement that stopped us in our tracks: “While markets continue to function well, the Bank will continue to ensure that the Canadian financial system has sufficient liquidity.”¹ We’ve been vocal about our concerns relating to the credit markets, especially if the coronavirus outbreak ends up suppressing economic activity for a sustained period of time. While there’s no evidence of this just yet, we suspect much of the urgency behind the recent rate cuts is intended to keep it that way.
There are costs to cutting rates, but they’re not as significant as the cost of inaction
Interestingly, the BoC made no reference to household debt levels in its statement on Wednesday. That’s unusual, given that the bank spent most of 2019 suggesting it should keep interest rates on hold to avoid exacerbating existing imbalances (e.g., high levels of household debt and certain segments of Canada’s housing market). No doubt, many will say that the bank shouldn’t be cutting rates given the high cost of doing so. While few would dispute that observation, we believe the bank has likely judged that the costs of staying on hold are much higher than the costs arising from lowering rates. In our view, the BoC probably believes, as we do, that there’s a rising risk of job losses and even recessions that requires more urgent attention.
The Bank of Canada isn’t alone in having to weigh the costs of cutting rates. The ECB is particularly constrained by the effective lower bound, and will no doubt be concerned about the health of its banking system. Meanwhile, the Bank of Japan is likely caught in a situation where it could be running out of bonds and exchange-traded funds to buy. The Fed, on the other hand, could be accused of fanning the flames of the equity market while hurting pensioners with even lower rates. More problematic still is the growing sense that most central banks won’t be able to unwind these virus-induced rate cuts for many years. For now, however, it’s clear to us that central banks believe the threat of the virus is the bigger concern and that inaction will be more costly in the long term.
1 “Bank of Canada lowers overnight rate target to 1¼ percent,” Bank of Canada, March 4, 2020. 2 “Next BOE Governor Signals Coordinated U.K. Response to Virus,” Bloomberg, March 4, 2020. 3 Bloomberg, March 4, 2020.
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