Market underestimates Canada rate cut risk amid NAFTA uncertainty

TORONTO (Reuters) - The market is too complacent about the prospect of further interest rate cuts from the Bank of Canada, some economists say, as an uncertain outlook for the NAFTA trade accord risks derailing an expected pick-up in Canada’s business spending.

A man is reflected in a window while walking past the Bank of Canada office in Ottawa, Ontario, Canada, May 25, 2016. REUTERS/Chris Wattie

The central bank expected in October that growth in business investment will turn positive in 2017 after disappointing in recent years. But Donald Trump’s surprise U.S. presidential election win has triggered uncertainty about the outlook for the North American Free Trade Agreement, which economists say will discourage investment.

“Even if trade isn’t disrupted from Canada, the uncertainty over our trade position with the U.S. will, if anything, delay the turn in capital spending,” said Nick Exarhos, economist at CIBC Capital Market, who sees Trump’s stance on trade damping Canada’s growth outlook.

Rising uncertainty surrounding the trade position has not translated into increased expectations for the Bank of Canada to lower interest rates despite it having considered a cut last month before holding its policy rate steady at 0.50 percent. It last cut in July 2015.

The market does not expect any change in rates through mid-2017, overnight index swaps data shows. A 30 percent chance of a cut was implied before the U.S. election on Nov. 8. BOCWATCH

Part of the shift in expectations is mechanical as the increased chances of hikes by the Federal Reserve interest rate help push Canada’s rates higher.

“We have seen markets price in a bit more tightening from the Fed into next year, which tends to have some sort of a pass- through into Canadian rates,” but Canada’s fundamentals “have not materially improved,” said Andrew Kelvin, senior rates strategist at TD Securities.

He estimates a 40 percent probability of another Bank of Canada rate cut during the current easing cycle.

To be sure, Canada may get a boost from proposed stimulus spending in the U.S., Canada’s largest trading partner.

“We might get some spillover effects, but I don’t think it would necessarily be enough to overcome some of the uncertainty or anxieties about U.S. trade policy,” said David Watt, chief economist at HSBC Bank Canada.

A recent spike in bond yields may also weigh on Canada’s economy.

“That means tighter financial conditions here in Canada, including the housing market, which was already subject to tougher macro-prudential regulations,” said Jimmy Jean, senior economist at Desjardins.

Reporting by Fergal Smith; Editing by Alan Crosby