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When the Bank of Canada issued its interest rate announcement at 9 a.m. on Oct. 19-keeping its benchmark overnight rate at 1%- RBC research point man Mark Chandler wrote and issued a report to RBC's traders and major clients within 20 minutes. Here's how it went.



WHAT THE BANK OF CANADA SAID

HOW RBC INTERPRETED IT

"The global economic recovery is entering a new phase. In advanced economies, temporary factors supporting growth in 2010-such as the inventory cycle and pent-up demand-have largely run their course and fiscal stimulus will shift to fiscal consolidation."

"We would characterize today's statement as considerably dovish in tone compared to the previous one in September," said RBC's Chandler. The tone of the statement is as important as the Bank's actual rate decision. In September (when the Bank raised interest rates a quarter point), it said an economic recovery was proceeding and that financial conditions remain "exceptionally stimulative." To Chandler, that was a sign of a "tightening bias," meaning that the Bank was ready to keep raising rates to choke off potential inflation. October's statement dwells more on signs of economic weakness.

"A weaker-than-projected recovery in the United States.…Heightened tensions in currency markets and related risks associated with global imbalances could result in a more protracted and difficult global recovery."



"As expected, there was some concern expressed at both the strength of the Canadian dollar and the expected uneven growth in the U.S. economy," said Chandler. The upshot: Canadian exports could suffer because of weak U.S. demand and a strong loonie, while other countries try to devalue their currencies to make their exports cheaper."

"The Bank expects…growth of 3.0% in 2010, 2.3% in 2011 and 2.6% in 2012."

"The statement captures downward revisions to the Bank's growth forecast from the last official release [in July]" noted Chandler. And they're hefty reductions.

"The Bank judges that the output gap is slightly larger and that the economy will return to full capacity by the end of 2012, rather than the beginning of that year."



"Importantly, [the statement]also pushes the expected time until the economy reaches full capacity out to 'the end of 2012' from an earlier estimate of 'the end of 2011,'" Chandler wrote in boldface type. This was the big news of the day: the persistence of what economists call the output gap-the difference between what Canada's economy would produce at full capacity, and what it's producing now. If the gap lasts until the end of 2012, there's less risk of inflation until then.

"This leaves considerable monetary stimulus in place, consistent with achieving the 2% inflation target."

"It is possible that a resumption of tightening in March is still in the cards, but the data would have to convince the Bank of Canada to upgrade current forecasts," said Chandler. The Bank is keeping rates low to stimulate the economy, and there's little risk this will heat up the economy enough to raise core inflation to 2%.





WHAT'S A YIELD CURVE Traders and analysts talk a lot about bond yield curves. So do economists and policy makers, who like their yield curves "upward-sloping"-a sign of a healthy economy. An "inverted yield curve" is scary-it usually means a recession is coming.

A yield curve is a chart of bond yields, with the bonds of shortest duration on the left, and the longest on the right. A full Government of Canada bond curve starts with issues due to mature within 30, 60 and 90 days, all the way out to 30-year bonds on the right. Traders and investors will also compare the GofC bond yield curve with those for U.S. Treasuries and corporate bond indexes.

In normal times, you'd expect short-term yields to be lower than long-term ones. If investors are going to hold a bond for 20 years, they'll want a higher yield than for a one-year bond, to compensate them for greater uncertainty and possible inflation. That's why yield curves tend to slope up to the right.

Interest rate decisions by central banks affect the yield curve, but the impact tends to be greater at the short end (five-year bonds or less) than the long end, which is guided more by investors' assumptions about long-term economic growth and inflation.

One risk Bank of Canada Governor Mark Carney faced before the Bank of Canada's Oct. 19 rate decision is that, if he kept increasing rates in a weak economy, he could eventually invert the yield curve-yank up short-term rates higher than long-term ones-and choke off borrowing and spending by consumers and businesses.



THE EXTREMELY HIGH-TECH/ODDLY ARCHAIC BUSINESS OF BOND TRADING There's no shortage of gadgets on a bond trader's desk. RBC's Jim Byrd and his traders each have five computer screens. Two of Byrd's screens display data from Canadian and U.S. bond brokers. One has current prices for all outstanding Government of Canada issues. One has numerical spreads that Byrd likes to follow-differences between, say, two-, five- and 10-year GofCs, comparisons with U.S. Treasuries, and so on. The fifth is a screen with a feed from Bloomberg financial news. Byrd also has a speaker with links to four inter-dealer trading services for Canadian bonds. A voice reads out prices continuously, like a taxi dispatcher.

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