Bank likely to expand corporate bond purchases - Capital Economics
Canada Economics

Bank likely to expand corporate bond purchases

Bank of Canada Watch
Written by Stephen Brown
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We expect the Bank of Canada to announce additional corporate bond purchases next week. If it wanted to do even more, the Bank would probably introduce a funding for lending program rather than take interest rates negative.

  • First meeting for new governor Tiff Macklem.
  • Some positive signs since last meeting, but some worrying ones as well.
  • Downside risks raise the case for more policy support.

We expect the Bank of Canada to announce additional corporate bond purchases next week. If it wanted to do even more, the Bank would probably introduce a funding for lending program rather than take interest rates negative.

Bank’s assets keep on rising

The Bank has had a busy six weeks since its last meeting, with the announcement that former Senior Deputy Governor Tiff Macklem will take over from Governor Stephen Poloz on 3rd June (i.e. the day of next week’s meeting). (See here.) The Bank has also been busy expanding its balance sheet, which has grown by $167bn, or 61%, since mid-April. Purchases of government securities have taken over from repo operations as the largest driver of the overall increase. (See Chart 1.)

Chart 1: Weekly Change in BoC Assets ($bn)

Sources: Bank of Canada, Capital Economics

Some reasons for optimism

In his last official speech before departing, Poloz noted that there are “encouraging signs” in terms of Canada’s progress since the peak of the outbreak. Certainly, it is encouraging that the growth of COIVD-19 cases has continued to slow and provinces are starting to re-open. The Apple Mobility Report shows car journeys have risen by 95% since Easter, while data from OpenTable showing restaurant bookings in Alberta and British Columbia have been quick to recover as restaurants re-opened. Moreover, oil prices have rallied sharply since April, while there has been a strong rebound in small business confidence. (See Chart 2.)

Chart 2: CFIB Small Business Confidence

Source: Bank of Canada, Capital Economics

Downside risks remain elevated

The topic of the speech was “dealing with extreme uncertainty”. His point was that, even if the probability of a better scenario than the baseline is the same as the probability of a worse one, the policy implications can be far different if the downside costs are greater than the upside benefits. That is often the case when interest rates are near-zero and it is certainly the case now. Our forecast for an 8.3% drop in GDP this year is worse than the consensus forecast for a 5.8% decline, and we expect GDP to be 5% lower in the fourth quarter than it was a year earlier. But even if conditions turn out better than we expect, GDP is likely to finish 2020 a few percent lower than it was at the end of 2019. In a worst-case scenario, GDP could be far lower than even we forecast; the Bank’s worst-case scenario is for GDP to finish 2020 24% lower than a year earlier.

The most likely way that downside scenario would occur is through a sharp deterioration in the housing market. On this front, the recent data are concerning. First, consumer confidence has been hit far harder than elsewhere. In the US, the Conference Board measure was just 0.2 standard deviations below its 10-year average in May. In Canada, consumer confidence is a full eight standard deviations below its 10-year average. (See Chart 3.)

Chart 3: Consumer Confidence
(Standard deviations away from 10-year average)

Source: Refinitiv, Capital Economics

The near halting of immigration into the country is already weighing on the rental market. With new arrivals dropping from around 30,000 per month to near-zero from March, it is hardly surprising that the rental reports from online listing sites Rentals.ca and Padmapper.com showed large falls in rents in April. (See Chart 4.) That might not cause widespread selling pressure, but it certainly raises the risk that some investors will sell their properties. (See here.)

There have admittedly been several occasions when we incorrectly thought the housing market’s day of reckoning had arrived. We were intrigued this week that 23% of homeowners are apparently considering buying a second property now that mortgage rates have fallen further. That is potentially several million new buyers and, to be fair, even historically-low rental yields look attractive when interest rates are likely to be at rock-bottom levels for years.

Chart 4: Rent for 2-Bed Properties (% m/m, April)

Sources: Bank of Canada, Capital Economics

Further asset purchases likely

It will still be a few months before it becomes clear how the economy and housing market is coping, but the downside risks suggest that the bias is still likely to be toward further policy support, especially as yield spreads for mortgage and corporate bonds are still elevated. (See Chart 5.)

Chart 5: Yield Spreads Versus 5-Year Gov. Bonds (bp)

Sources: Refintiv, Capital Economics

We see this as a sign that the Bank’s planned corporate bond purchases in particular are too small. It plans to buy just $10bn of bonds, which is less than 0.3% of corporate debt outstanding even before the outbreak. We therefore expect the Bank to announce next week that it will buy at least $50bn of corporate bonds instead.

There has been some speculation that the Bank could soon take interest rates negative, particularly with a new governor at the helm. As Macklem has not been that vocal about his views on policy since leaving the Bank, we have little way to judge whether he is more supportive of negative rates than Poloz. Certainly, Macklem toed the company line and said that they were unlikely to be used when his appointment was announced. The chance of negative rates being implemented could also increase if Senior Deputy Governor Carolyn Wilkins, who was looked over for the governor post, decides to resign. Given the current situation, we think it more likely Wilkins will work out the remaining 12 months of her term.

As we noted elsewhere (see here), Canada is better placed to deal with the side-effects of negative rates than most countries that have implemented them so far. However, we think the Bank could avoid the side-effects entirely by just implementing a funding-for-lending program with negative funding costs for lenders that meet pre-set lending requirements.

Table 1: Bank of Canada Background Information

Policy Interest Rate Announcements

The Bank of Canada has a system of eight pre-set dates per year on which it announces its target for the overnight interest rate (10.00am EST).

Release of Minutes

No. However, the Bank’s Monetary Policy Report (MPR), published four times a year, provides considerable detail on the Governing Council’s outlook for economic activity and inflation, the key risks around this outlook, and the reasons for the recent interest rate decision.

Disclosure of Voting

No.

Inflation Target

Yes. The Bank aims to keep inflation at 2%, the midpoint of a 1% to 3% range.

Policy Framework

Canada’s monetary policy is built on a framework consisting of two key components. The first component is a flexible exchange rate, which permits independent monetary policy. The second component is the inflation target of 2%, which provides a precise goal to measure the conduct of monetary policy.

Membership of the Governing Council

The Governing Council is the policy-making body of the Bank. It consists of the Governor, Senior Deputy Governor, and four Deputy Governors.

Governor

Stephen Poloz (To be replaced by Tiff Macklem from 3rd June)

Senior Deputy Governor

Carolyn Wilkins

Deputy Governors

Timothy Lane

Lawrence Schembri

Paul Beaudry
Toni Gravelle

Fixed Announcement Dates

Date

Outcome / Our Forecast

July 10th

No Change (Rate stayed at 1.75%)

September 4th

No Change (Rate stayed at 1.75%)

October 30th

No Change (Rate stayed at 1.75%)

December 4th

No Change (Rate stayed at 1.75%)

January 22nd 2020

No Change (Rate stayed at 1.75%)

March 4th

Cut (Rate reduced to 1.25%)

March 13th

Cut (Rate reduced to 0.75%)

March 27th

Cut (Rate reduced to 0.25%)

April 15th

No Change (Rate to stay at 0.25%)

June 3rd

No Change (Rate to stay at 0.25%)

July 15th

No Change (Rate to stay at 0.25%)

September 9th

No Change (Rate to stay at 0.25%)

October 28th

No Change (Rate to stay at 0.25%)

December 9th

No Change (Rate to stay at 0.25%)

Sources: Bank of Canada, CE


Stephen Brown, Senior Canada Economist, +1 416 874 0514, stephen.brown@capitaleconomics.com