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A general view of the Bank of Canada building in Ottawa. The Bank will make an interest rate announcement on Tuesday.


Friday's inflation release by Statistics Canada was discouraging, as both headline inflation and core inflation came in well below the Bank of Canada's target of 2 per cent. By itself, lower-than-target inflation does not mean that the Bank needs to loosen monetary policy. Monetary policy works with a lag, so one needs to consider other indicators to see not just where the economy is, but where the economy is headed.

There are a number of market indicators available, including real return bonds and short-term bond rates. One of the most-useful indicators of the medium-term health of the economy is the nominal Government of Canada benchmark ten-year bond yield.

With a 2-per-cent target, these yearly yields are normally in the range of 4- to 5 per cent, giving investors a 2- to 3 per cent real return after inflation. Yields started to decline a year before the financial crisis. In the last twelve months, the yields on these bonds have absolutely collapsed, going from more than 3 per cent to less than 2. Even during the 2008-2009 crisis period, yields stayed above 2.5 per cent a year. Expect these yields to stay at historic lows for the near future; the Bank of Montreal predicts they will remain under 2 per cent until late 2013. This should spark serious concerns, as these yields are eerily reminiscent of Japanese 10-year bond yields in the late 1990s.

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There could be several causes of these low bond yields - and none of them are pleasant. It may be that bond markets expect the Bank of Canada to undershoot its 2 per cent inflation target for the foreseeable future. It may be that alternative investments in Canada are such losing propositions that people are willing to accept low or even negative real returns. Finally, there may be a flight to quality here, with Canada being seen as a safe haven in a world full of economic turmoil. It is likely a combination of all three.

Bond markets are screaming loud and clear that worldwide demand remains low, and, in the medium-term, inflation is likely to stay under the Bank of Canada's target. On Tuesday, the Bank of Canada will be giving its interest rate announcement. Given the current economic data and low inflation, the prudent move for Mark Carney is to lower the overnight rate by 25 basis points.

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