A year ago at this time, Bank of Canada Governor Stephen Poloz stunned the financial markets with a surprise interest-rate cut in the teeth of a tumbling oil price and a slumping economy. Now, with oil's renewed slide threatening to derail Canada's 2016 economic prospects, the markets are steeling themselves for a repeat performance from Mr. Poloz this week – though it's far from a sure thing.
"Consensus is divided. Markets are increasingly expecting a cut. Nobody is telling a story with great conviction. Governor Poloz doesn't sound like he'll cut, but maybe he will. It's not the least bit clear that the benefits outweigh the costs," Bank of Nova Scotia economist Derek Holt wrote in a research report.
The Bank of Canada will announce its latest interest-rate decision on Wednesday, the first of eight scheduled rate announcements throughout the year.
Up until a couple of weeks ago, it was assumed that the central bank would leave its key rate unchanged at 0.5 per cent, where it has sat for the past six months after a pair of quarter-percentage-point cuts in January and July, although the bank was expected to trim its outlook on the economy. But after a week of further losses in oil and the Canadian dollar, as well as new evidence of the growing unease weighing down Canada's corporate sector, central bank watchers have come around to a real possibility that Mr. Poloz will cut his rate again this week.
The market is still fairly split on the matter: The yields on overnight index swaps in the bond market imply that traders, as of Friday afternoon, were pricing in a 62-per-cent chance of a cut in Wednesday's decision.
"It's still a close call, one we would not day-trade on," said Avery Shenfeld, chief economist at Canadian Imperial Bank of Commerce.
But just a week earlier, they were pricing in a 15-per-cent chance of a cut. The sea change in thinking was triggered by last Monday's release of the Bank of Canada's quarterly Business Outlook Survey. The report revealed a marked deterioration in sentiment among Canadian businesses, as the ill effects of the global commodity slump are weighing on investment and hiring intentions, as well as inflation expectations, and are increasingly infecting the non-resource economy. That put the possibility of a near-term rate cut firmly on the table, as Mr. Poloz has always given considerable weight to business sentiment in his approach to monetary policy.
Heightening those concerns is the continued slide of oil prices. Conditions for the energy sector, and everything affected by it, have worsened considerably since the Business Outlook Survey was conducted in late November and early December. In the six weeks since the survey was completed, the price of West Texas intermediate crude has fallen by nearly $8 (U.S.) a barrel, or more than 20 per cent. That has triggered another big sell-off in the Canadian dollar, which dipped below 69 cents on Friday – sparking new concerns that a currency-related rise in costs for imports, especially food, will squeeze Canadian consumer spending.
Still, in recent public comments, Mr. Poloz hasn't given off the sense of a central banker who's leaning toward cutting. In his news conference following a Jan. 7 speech, he remained relatively upbeat about Canada's prospects for an economic recovery fuelled by non-resource export growth. And in the speech itself, he stressed that a flexible exchange rate is the most effective tool to help absorb the shock Canada's economy is going through. The implication is that he may consider that the currency's most recent declines will provide the needed stimulus to foster that non-resource export resurgence – perhaps making another rate cut not only unnecessary, but counterproductive.
"The Canadian dollar has already taken a mighty blow, and a further rate cut would risk a much deeper slide … which could ultimately do more harm than good for the economy," Bank of Montreal economists Douglas Porter and Benjamin Reitzes said in a research note.
At least as important as the interest-rate decision itself will be the bank's Monetary Policy Report, its quarterly update of its outlook for the Canadian and global economies, which will be released simultaneously with the rate announcement. The bank's estimates for Canadian economic growth contained in its October MPR – 1.1 per cent for 2015 and 2 per cent for 2016 – now look overly optimistic, given the economy's deteriorating fundamentals. Most economists now think the economy will be lucky to grow by more than 1.5 per cent this year.
If the Bank of Canada's forecast agrees with that view, it would suggest that the economy will grow below the pace necessary to absorb the economy's excess capacity. That would imply that even if it doesn't cut its rate now, another cut would soon be in the cards unless conditions improve.
"Even if the bank doesn't actually cut, they will certainly use language to convey a much higher likelihood of a rate cut ahead," Mr. Shenfeld said.