Canadian Rate Cut Carillon Grows Louder After Economy Contracts

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Investors who say Canada’s economy is in a deeper hole than the central bank estimates are making bolder bets that more interest rate cuts are needed to revive growth.

The yield on December 2015 Bankers’ Acceptance contracts, a measure of where traders project short-term rates will be over the course of the agreement, saw the biggest one-day decline in two months on Friday. Traders are revisiting the possibility of a rate cut after data showed the economy contracted last quarter by the most since the 2009 recession.

Bank of Canada Governor Stephen Poloz has said his 25 basis point rate cut in January is all the stimulus the economy needs to rebound from a collapse in oil prices that peaked in March. Now, investors have pushed the yield on the two-year government bond to 0.57 percent, or almost 25 basis points below the central bank’s 0.75 percent lending rate.

“Poloz had said they expect the impact of the oil decline to be front loaded but not larger, and I think this suggests maybe the impact was somewhat larger than the Bank of Canada anticipated,” said David Watt, chief economist at the Canadian unit of HSBC Holdings Plc. “So the question is, is it going to be larger and longer lasting? That’s my view.”

Watt forecasts two more 25 basis point cuts, coming in the third and fourth quarter of this year.

Alternative View

That’s still a minority opinion among economists, with the median estimate of a Bloomberg survey of 17 economists saying the bank’s next move will be to increase rates next year rather than lower them.

Bankers’ Acceptance contracts, or so-called Bax contracts, have settled about 20 basis points above the central bank’s target rate on average since 1992, data compiled by Bloomberg show. On Friday, the yield on the December 2015 contract fell four basis points to 0.90 percent.

“Bax contracts are now pricing in eases from the BoC after the worse than expected GDP data,” said David Love, an independent trader of interest-rate derivatives at Jitneytrade Inc. in Montreal. “The July meeting will be interesting, as Poloz may opt to take out more insurance.”

Love estimates the chance of a rate cut implied by the December contract has gone from about 20 percent at the beginning of last week to as high as 50 percent.

Slower Growth

Another part of the market is suggesting greater chances for a rate cut even further out. The difference between yields on six-month and two-year government debt reached its widest since mid-April last week, with both trading below the central bank’s overnight rate. The spread reached 8 basis points.

The 0.6 percent economic contraction Canada saw between January and March was worse than the forecast for flat growth the Bank of Canada made in April.

“Markets are pricing in some chance of cuts beyond six months,” said Andrew Kelvin, senior fixed-income strategist at Toronto-Dominion Bank, in an e-mail.

Mark Chandler, head of fixed-income research at Royal Bank of Canada, who predicts the central bank’s next move will be to raise rates, said the odds of a cut have increased.

“You’re starting in the hole for Q2 growth,” Chandler said by phone from Toronto. “The market should be pricing in more potential for a rate cut, even though the bank ultimately may resist that temptation.”

The loonie, as the Canadian dollar is known for the image of the aquatic bird on the C$1 coin, fell 0.4 percent to C$1.2480 per U.S. dollar on Friday, close to the lowest since April 15.

More Insurance

“We need a weaker Canadian dollar to provide a competitive boost to our export sector to help provide growth,” said Todd Mattina, chief economist and strategist at Mackenzie Investments in Toronto, which oversees about C$70 billion in mutual funds. “The likelihood of a rate cut is increasing given that the risks to growth are titled to the downside.”

The median forecast among strategists surveyed by Bloomberg is for the loonie to weaken to C$1.26 next quarter.

“The Bank of Canada’s single 25 basis point rate cut in January may not have been enough insurance against the oil price slump after all,” Paul Ashworth, chief North America economist at Capital Economics, wrote in a note to clients after last week’s GDP report. ‘The evident weakness triggered by the oil price slump supports our view that the Bank of Canada will need to lower interest rates again before the end of this year.’’

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