The Bank of Canada's latest communiqué put it squarely in wait-and-see, data-dependent mode on interest rates, causing market participants to doubt whether further stimulus is in the offing.
But along with economic data, monetary policymakers clearly articulated their focus on financial conditions, which provides a few clues as to what could prompt the central bank to cut rates again.
The March statement was brief, as is common for interest rate decisions not accompanied by a Monetary Policy Report, but it did include a paragraph in which the Governing Council paid tribute to how financial conditions had "eased materially" since the Bank took out some insurance in January by reducing the overnight rate.
In his post mortem of the recent rate decision, TD Securities chief Canada macro strategist David Tulk noted the Bank's emphasis on financial conditions.
"While data dependency is core to the next move in the overnight rate, the evolution of financial conditions are now equally important," he wrote.
Long-time Bank of Canada followers may find this renewed focus on financial conditions to be a "back to the future" move for the central bank. After all, the Bank of Canada used a monetary conditions index, composed of the interest rate on 90-day commercial paper and a trade-weighted index of the Canadian dollar, as an operational target for monetary policy back in the 1990s.
The more broad Financial Conditions Index (FCI) developed by the Bank includes credit conditions, the corporate bond spread, short and long term interest rates, the real exchange rate, stock prices, and home values as its components.
As of March 6th, this index was sitting at 1.49 – above its level at the time of the reduction to the overnight rate in January (indicating that financial conditions have improved), but below where it was in early December. Granted, some of the variables in the FCI enter this equation with a lag. The real exchange rate, for instance, is a component that will contribute to the easing of financial conditions going forward.
But Mr. Tulk, who formerly worked at the central bank, warned that "financial conditions can be a fickle bedfellow."
And outside of the exchange rate, there are precious few signs that financial conditions have eased materially in a manner that will benefit the real economy.
Per RateHub, the average discounted five-year fixed mortgage rate, the dominant product in the market, has declined by about 15 basis points to 2.54 per cent. Variable rate mortgage holders also had 15 basis points of the Bank of Canada's cut passed along by lenders.
"It is doubtful that a 15-basis points reduction in the prime rate will lead to a wave of new borrowing," said Benjamin Tal, deputy chief economist at CIBC World Markets.
Using the iShares Canadian Corporate Bond Index and HYBrid Corporate Bond Index ETFs as proxies, borrowing costs for Canadian firms have marginally decreased since January 20th, the day before the Bank of Canada lowered the overnight rate.
Meanwhile, the yield on ten-year Government of Canada debt has actually increased over this stretch, with the nation importing higher rates from the United States that have been driven by the prospect of a tightening phase from the Federal Reserve commencing shortly.
Even with regards to the exchange rate, the data suggests it is U.S. dollar strength, rather than softness in the loonie, that has been the principal driver of the pair. The Canadian-dollar effective exchange rate index, a trade-weighted average of the loonie relative to currencies of the nation's largest trading partners, is down more than 3 per cent since January 20th. Excluding the greenback, this index is flat over the same period.
This, to Mr. Tal, suggests that "we could have bought at least a portion of that insurance for free."
Canadian investors should be aware that a notable appreciation in the value of the loonie relative to the U.S. dollar, particularly if due to weakness in the U.S. half of the pair, would undo the prime channel through which financial conditions have eased. This would increase the odds of the central bank taking out additional insurance, particularly if yields failed to fall in sympathy with any retreat in the greenback.
And with sentiment on the Canadian dollar increasingly negative, the pair is vulnerable to an abrupt reversal should the vast amount of shorts seek to unwind those positions en masse if economic data surprises to the upside or West Texas Intermediate crude oil appears to make a decisive move above $50 per barrel (U.S.).