August 10, 2011 / 7:08 PM / in 6 years

Analysis: Canada rates seen lower for longer; cuts unlikely

<p>Bank of Canada Governor Mark Carney walks from his office to a news conference upon the release of the Monetary Policy Report in Ottawa July 20, 2011. REUTERS/Chris Wattie</p>

TORONTO (Reuters) - A dovish U.S. Federal Reserve will likely force the Bank of Canada to keep its interest rates lower for longer, but market bets on a Canadian rate cut by year-end are unlikely to pay off.

Analysts said a rate cut would send all the wrong signals for an economy that is growing, albeit slowly, and could hurt the central bank’s credibility.

“In the current situation, a rate cut by the Bank of Canada would mean that you have a second recession in Canada,” said , Charles St-Arnaud, Canadian economist and currency strategist at Nomura Securities International in New York.

“And that’s not something that we see happening.”

Expectations for Canadian interest rates have swung wildly in recent weeks. As recently as July 19 traders priced in higher expectations of a rate increase this year, following unexpectedly hawkish language from the Bank of Canada.

A July 20 survey of primary dealers showed most saw a rate hike in September or October.

But tightening expectations fell sharply as the U.S. debt ceiling debate and the downgrading of the U.S. credit rating by Standard & Poor’s fueled fears of a recession there, triggering some of the worst stock market selloffs since the collapse of Lehman Brothers in 2008.

Canadian overnight index swaps, which trade based on expectations for the Bank of Canada’s key policy rate, and short-dated government debt began to show expectations of a rate cut rather than an increase.

The Canadian dollar also fell more than a nickel against the greenback as the outlook for monetary policy moved from tightening to easing.

Rate cut expectations were reinforced by the U.S. Federal Reserve’s unprecedented announcement on Tuesday that it would likely keep rates near zero for another two years.

Analysts said the Bank of Canada is likely to keep interest rates lower for longer than previously expected because of the Fed move. One issue is that widening the rate differential between the two countries could cause an unwelcome appreciation in the Canadian dollar.

But they caution that swap markets, which are pricing in a quarter-point rate cut before year end, have it wrong.

Analysts said a cut is not needed because the Canadian economy, though highly dependent on the big U.S. market, is still growing. The central bank’s key policy rate, currently at 1.0 percent, is also seen as still being very accommodative. The rate was cut to a record low of 0.25 percent after the financial crisis.

HOUSING, RISK TO CONFIDENCE FACTORS

Those emergency rates provided conditions for the domestic housing market to surge to bubble-like proportions in some parts of the country, and allowed Canadians to take on massive personal debt loads.

Analysts said a rate cut could reignite these two segments of the economy, risks that have already been flagged by the central bank.

“The bank is going to need a lot more evidence that the downside risks are going to stick with us before they totally rewrite their script from the last statement and move toward outright easing,” said Derek Holt, an economist at Scotia Capital, noting that dovish language would inevitably have to accompany a decrease in the central bank’s key rate.

“That would be a blow to business and consumer confidence in the country as opposed to the more supportive role, which would be essentially to just stay off on the sidelines and not do anything on rates for a long time yet.”

Holt is already the most bearish among Canada’s 12 primary dealers -- institutions that deal directly with the central bank as it carries out monetary policy -- and is comfortable with his call that the next rate hike will be in the second quarter next year.

If anything, it could be later, “if the Fed is true to its word in terms of maintaining stimulative policy all of next year and into 2013,” he said.

Analysts said the risk of a rate cut is now more likely than an increase, given Canada’s trading ties to the United States and the risk that a recession there would also pull Canada’s economy lower.

“It is probably appropriate to price in some risk of the next move by the BoC being more a cut than a hike, just at this stage,” said Michael Gregory, senior economist at BMO Capital Markets.

“But I think that fades within six months and you start to believe that is going to skew to the next risk being a hike rather than a cut.”

($1=$0.99 Canadian)

Editing by Jeffrey Hodgson and Rob Wilson

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