On Tuesday afternoon, Governor Stephen Poloz gave the loonie back its wings.
The Canadian dollar surged against the U.S. dollar, rising seven-tenths of a cent to above 80 cents following some unexpected commentary from the head of the Bank of Canada.
In mid-October, the Bank of Canada said that it was abandoning the practice of forward guidance – that is, monetary policymakers would no longer provide market participants with information about the timing or direction of the next movement in the overnight rate. However, the governor appeared to drop a hint today.
The subject matter of Mr. Poloz's speech was of a somewhat hawkish bent, as the governor focused on the need to monitor the health of the financial system. "Low and stable inflation is a necessary, but not sufficient, condition for financial stability," he said. The topic of financial stability was invoked much more frequently by Mr. Poloz's predecessor, Mark Carney, who often warned Canadian households about the dangers of elevated indebtedness.
Market participants, however, keyed in on one statement that strongly suggests another rate cut from the central bank is not as imminent as one would have imagined.
"So the downside risk insurance from the interest rate cut buys us some time to see how the economy actually responds," Mr. Poloz said in his concluding remarks.
The implication of this statement is that the central bank will wait to determine whether more monetary stimulus is required to offset the "unambiguously negative" effect of the decline in oil prices.
Market participants quickly digested this new information and began to bet against a Bank of Canada rate cut next week.
On Monday, the overnight index swap market was pricing in an 82 per cent chance of 25 basis point reduction in the overnight rate to 0.5 per cent on March 4th. This belief was supported by persistently low oil prices and underwhelming economic data. Soon after Mr. Poloz's remarks were released, the overnight index swaps suggest the consensus view is for the bank to stand pat: the implied odds of a rate cut, as of the close on Tuesday, stand at 42 per cent.
However, it's reasonable to wonder how long the bank would be able to remain patient. Since changes in monetary policy have a lagged effect on economic activity, its practitioners are forced to try to be as proactive as possible. And as the governor said just prior to his market-moving comment, the negative effects of lower oil prices are immediate, while the positives take time to manifest.
CIBC World Markets senior economist Peter Buchanan wrote that this speech "does nothing to alter our view that the bank will cut rates one more time, most likely in a week's time but failing that at the following meeting in April."
Scotiabank economist Derek Holt, however, said he thinks that Mr. Poloz is setting up for a unexpected pause at its policy announcement next week. "In our view this says that the Bank of Canada is shifting to data dependency and will condition further possible easing upon how the data and market metrics like oil prices evolve over time," he said in a note.
The overnight index swap market is reflecting a still widely held belief that another rate cut will come this spring, pricing in a 72 per cent chance of at least one rate cut by April.
Deputy Governor Timothy Lane's speech about a week and a half prior to the Bank of Canada's latest announcement provided little in the way of a hint at the central bank's action. This bout of commentary from the governor, however, is much more direct, and as Bank of Montreal senior economist Benjamin Reitzes said, "inserts a lot more uncertainty into next week's policy meeting, making a potential rate cut a toss-up."
That being said, Governor Poloz has shown that he is more than willing to surprise the markets, and a cut next week was not explicitly ruled out.
The loonie also gained ground on other major currencies, including a massive intraday reversal that saw it pare its losses against the Mexican peso to 0.7 per cent from 1.7 per cent.
Canadian fixed income also weakened on the heels of the governor's comments, particularly in the front end of the curve. The yield on the three-month Government of Canada bill rose to 0.6 per cent from 0.47 per cent.