Bank of Canada Teases, but No Satisfaction

The Bank of Canada's statement yesterday steals whatever importance investors may have attributed to the acceleration of inflation in March.  Headline CPI rose to 1.5% from 1.1% and the core rate rose to 1.3% from 1.2%.  

Governor Poloz indicated that the central bank would look past the near-term pick-up in inflation because it is likely a function of factors that may not be sustained, including the past decline in the Canadian dollar. The Canadian dollar is the worst performing major currency over the past six months, declining 6.6% against the US dollar. However, those losses were concentrated in the first half of that period.  Over the past three months, the Canadian dollar is essentially flat (off 0.5%).  

The Bank of Canada acknowledges that it is still nearly two years from closing, but is reluctant to reduce interest rate further.  It says that it anticipates a gradual strengthening of fundamental economic drivers, but recognizes that the necessary transition in the economy has yet to take place.  This is a shift from final demand from the heavily indebted households toward exports and business investment.  We suspect this transition will remain elusive in the coming quarters.  

There was a large build up of inventories late last year.  These appear to have largely been worked off in Q1, but the inventory cycle and the weather shock depressed growth at the start of the year.  The Bank of Canada expects Q1 GDP near 1.5%, which is somewhat slower than it had anticipated a few months ago.   Nevertheless, it expects the economy to bounce back in Q2 and see GDP at 2.5%.   It is the lower performance in Q1 that is reflected in its decision to shave 2014 growth to 2.3% from 2.5%.  

The Bank of Canada economic forecasts assume the Canadian dollar will be broadly stable around $0.91 (~CAD1.10).  This is its average so far this year.  Volatility is low.  Three-month implied vol has been largely confined to a 6%-8% range for the better part of two years.  This is just above the lows seen since 2000.   

We are less sanguine and see the recent US dollar pullback as a correction to the uptrend.  Near-term we look for the US dollar to recover.  The first test for the bulls is seen near CAD1.1120.  A convincing break would likely signal a retest on the CAD1.1300. 

The Bank of Canada outlined three conditions that could trigger a policy change.  First, if inflation were to fall further, a rate cut would have to be considered.  However, this does not seem particularly likely.  In fact, the low point in Canada's inflation cycle may be behind it.  The base effects should lift the headline readings in the coming months except in May, before falling back off in Q4.  

Second, the BOC warned that if spending from the household sector slows to quickly this could also put at risk its neutral stance. The stronger employment gain and real wage increases will likely underpin consumption.  Third, the Bank of Canada warned that a change in policy could be warranted if the housing sector correction turn violent.   It continues to anticipate a soft landing.    The poor weather in Q1 contributed to the distortion of some of the housing data.  This is the least transparent of the BOC's three conditions and seems to be the weak link and it is the one investors need to watch most closely.