“After spending two years watching house prices and household debt measures, investors may spend 2014 focused on inflation reports when making bets on the Bank of Canada’s interest rate outlook.”
The slow pace of consumer price inflation surprised policy makers in 2013, reviving rate-cut bets and prompting the central bank to abandon its bias to raise borrowing costs. Bank of Canada Governor Stephen Poloz said in an interview last month he can’t explain the weak inflation, which is now almost a percentage point below where the bank forecast it would be at the start of last year.
“A lot of people are starting to position for CPI releases,” Mazen Issa, senior macro strategist at Toronto-Dominion Bank’s TD Securities unit in Toronto, said in a telephone interview. “Inflation is going to be one of the major stories for Canada” this year.
Statistics Canada reported Dec. 20 that annual inflation in November was 0.9%, unexpectedly staying below the central bank’s 1% to 3% target band. The difference between Canadian and U.S. two-year yields narrowed by 4.22 basis points, the largest one-day reaction to Canadian CPI data since September 2011, when inflation was above the target band.
Inflation below 1% gives the Bank of Canada “plenty of reason to be dovish,” said Camilla Sutton, chief currency strategist at Bank of Nova Scotia in Toronto. The Dec. 20 report was “a disappointment because the market thought we would go back into to that 1 to 3%” target band.
Linkers Losing
The Bank of America Merrill Lynch Canada Inflation-Linked Government Index, which tracks six bonds with a face value of about $45 billion, lost 0.3% between the inflation report and Thursday, compared with a 0.2% gain for U.S. linkers.
Inflation has been below the 2% midpoint of the central bank’s target for 19 consecutive months. The bank forecasts it won’t return to that level for another two years. That would mark the longest stretch of inflation below the goal since the country adopted inflation targeting in the early 1990s.
In 2012, policy makers and investors were focusing on rising consumer debt. With near historic low mortgage rates sparking a rally in Canadian house prices and fuelling record debt levels, the central bank singled out household indebtedness as the greatest domestic threat to the economy. It introduced a rate-rise bias in April of that year, making it the only G-7 central bank to hint at higher borrowing costs.
Rate Bets
A year ago today, investors priced in more than 21 basis points of tightening by the end of 2013, trading in overnight index swaps showed. Economists surveyed by Bloomberg last January forecast a rate increase by the end of the year.
Today, swaps trading shows rate-cut bets have increased, meaning investors forecasting a change are roughly balanced between rate cuts and increases during 2014.
Elsewhere in credit markets, the extra yield investors demand to own the debt of Canadian investment-grade corporations rather than of the federal government fell 1 basis point Thursday to 118 basis points, or 1.18 percentage points, according to the Bank of America Merrill Lynch Canada Corporate Index. Yields fell to 3.11% from 3.14%. In 2013 the spread narrowed 17 basis points.
Yields on provincial debt relative to federal benchmarks fell 1 basis point to 64 basis points and narrowed 11 basis points in 2013, according Bank of America’s Canadian Provincial & Municipal Index. Yields were 3.07%, compared with 3.09% on Dec. 31 and 2.55% at the start of 2013.
Corporate Debt
Corporate debt returned 0.8% in 2013, compared with losses of 2.3% for provincial debt and federal-government securities, Merrill Lynch indexes show.
The difference in yields between Canadian and U.S. two-year notes — one gauge of relative interest rate expectations — fell from 91.6 basis points at the start of 2013 to 75.5 basis points at 8:14 a.m. in Toronto.
That spread moved sharply after Poloz, who replaced Mark Carney as governor in June, completely abandoned the central bank’s bias at his Oct. 23 rate announcement and began to single out weak inflation as the biggest risk to the economy.
At 1%, Canada’s benchmark rate remains the highest in the G-7.
“Under Carney, there was a shift in terms of focusing on financial stability risks,” said David Watt, chief economist at the Canadian unit of HSBC Holdings Plc. “Under Poloz, there has certainly been a return in focus towards what the Bank of Canada is mandated to look at, which is inflation.”
Core Inflation
Inflation last year averaged 0.9% through November, the slowest since the 2009 recession, falling to as low as 0.4% and never surpassing 1.3%. Core inflation, which excludes eight volatile components and is monitored closely by the bank as a gauge of inflationary pressures, averaged 1.2% last year and never fell below 1%.
“If core inflation is becoming unhinged, then you start to be concerned with the risk that the Bank of Canada may have to think a little bit more seriously about rate cuts,” Issa said.
