Bank of Canada’s war on inflation generates uncertainty among investors

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Nearly a year after the Bank of Canada declared war on inflation, investors have no idea what’s coming next.

On Wednesday, the central bank is set to announce its next decision on interest rates, and another hike looks probable. That would make for eight consecutive increases since March, taking the country’s policy rate to its highest level in at least 15 years.

But there is little consensus over how the Bank of Canada will choose to proceed.

Financial markets are putting the odds of a 25-basis-point hike at about 70 per cent. That’s the lowest level of confidence in a hike since the string of rate increases began, and it’s far lower than the 95-per-cent probability the market has placed on a United States Federal Reserve rate hike next week. The uncertainty signals that a policy pivot in Canada may not be far off.

That’s just what investors have been waiting for.

For years, central bankers were reliable allies to stock market investors. While there is no mandate for either the Bank of Canada or the Fed to prop up financial markets, it certainly seemed like they were quick to intervene in moments of financial stress.

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Long after the global financial crisis faded, interest rates were maintained at crisis levels indefinitely. It took more than eight years for the Bank of Canada to raise its policy rate above 1.5 per cent. The Fed took a similar path, and also embarked on stimulus programs known as quantitative easing.

Those extraordinary measures fuelled one of the longest bull markets in U.S. stock market history. Investors came to count on the undying support of central bankers. Eventually, inflation turned that relationship on its head.

In just nine months, the Bank of Canada raised its benchmark rate from 0.25 per cent to 4.25 per cent. Higher rates weigh on stock prices in a few different ways. Valuations go down, risk appetite declines and corporate earnings take a hit from higher borrowing costs.

Markets have bounced around in recent months on conflicting signals about when monetary policy might realign with investors’ interests.

“The central bank is not there to please the markets,” National Bank economists Matthieu Arseneau and Taylor Schleich said in a note. They pointed to the market’s poor recent track record of predicting Bank of Canada moves.

Five of the past eight rate decisions have come in either higher or lower than the consensus forecast. Clearly, the Bank of Canada is comfortable with diverging from investor expectations.

Part of the difficulty in anticipating the bank’s moves is that it is dependent on economic data, which is a jumble of confusing and contradictory indicators. While real estate has corrected sharply, for example, the jobs market is still humming along, with unemployment near record lows.

All the while, inflation has proven difficult to conquer. But December’s readings showed some promise. Annual Consumer Price Index growth for the month fell to 6.3 per cent, down from 6.8 per cent the prior month. It peaked at 8.1 per cent in June.

That’s enough of a moderation for some economists, who are calling on the Bank of Canada to relent. “The most aggressive policy rate increase in a generation is taking a toll on the economy,” the National Bank economists wrote.

Any further increase to the overnight rate “could be the straw that breaks the camel’s back.”

A pair of Bank of Canada surveys released last week suggest that both consumer and business sentiment is falling, with most respondents now anticipating a recession this year. Meanwhile, soaring mortgage rates are weighing heavily on the Canadian housing market.

“What keeps us awake at night is the sharp decline in home sales,” Canaccord Genuity portfolio strategist Martin Roberge said in a note. National sale activity for the month of December was down by 39.1 per cent over the prior year, according to figures released by the Canadian Real Estate Association last week.

Odds are, however, the Bank of Canada still hikes on Wednesday. “After this hike, we expect the central bank to adopt a wait-and-see approach,” Mr. Roberge said.

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