Oil Shock Taking Canada Toward Recession May Prompt Rate Cut

Canada’s central bank may cut its key lending rate Wednesday for the second time this year, a decision that hinges on whether Governor Stephen Poloz views an oil shock as having broadened into a recession.

Fifteen of 29 economists surveyed by Bloomberg predict the overnight rate will be reduced to 0.5 percent in an announcement due at 10 a.m. in Ottawa. The others -- who fear further inflating a debt bubble -- say it will remain at 0.75 percent, where it’s been since a cut in January.

The world’s 11th largest economy has shrunk four straight months through April, with export weakness spreading from energy to the factory goods Poloz counted on for a rebound from an “atrocious” first quarter. The governor’s revamped forecast, which he will discuss at an 11:15 a.m. press conference, must also weigh whether to say explicitly the economy is in recession and offer a new path to recovery ahead of an October federal election.

“We are in a deeper growth pothole than initially believed,” said Mazen Issa, senior foreign exchange strategist at TD Securities in New York. “Given how the very poor data has unfolded over the past of couple of weeks and the risk you are in recession, you’ve got almost a green light to provide additional stimulus.”

Toronto-Dominion Bank, Bank of America Merrill Lynch, BNP Paribas SA and Citigroup Inc. say Canada probably fell into recession in the first half of 2015. Output shrank at a 0.6 percent annualized pace in the first quarter and contracted 0.1 percent in April.

“The Canadian economy just hasn’t performed the way the Bank of Canada anticipated,” said David Watt, chief economist at HSBC Holdings Plc’s Canadian unit in Toronto, who predicts a rate cut. “Something is misfiring in the Canadian economy and someone has to step up and give it a jolt.”

Market Outlook

Some investors are betting that jolt will come Wednesday. Canadian stocks extended the biggest rally since February, as energy shares rebounded from the worst week in six months and materials producers jumped ahead of the Bank of Canada’s decision. The Standard & Poor’s/TSX Composite Index rose 66.18 points, or 0.5 percent, to close at 14,599.40 Tuesday in Toronto.

Two-year government bond yields, among the most sensitive to changes in central bank policy, declined to 0.46 percent Tuesday from 0.64 percent on June 26. And trading in overnight index swaps shows about a 50 percent chance of a cut, reflecting the split among forecasters.

In April, the the central bank predicted second-quarter growth of 1.8 percent. Poloz said the “front-loaded” oil shock would be replaced by positive forces around the second half of the year, including non-energy exports and consumers lifted by cheaper gasoline.

Falling Shipments

Instead, falling mineral and metal shipments led to a fifth straight export decline in May, making the year-to-date trade deficit the largest on record. Those losses come with manufacturing being aided by a weaker dollar, cheaper energy and a recovery in the U.S., which buys three-quarters of Canada’s exports.

Lower crude oil prices and a lack of pipelines are also prompting producers from Suncor Energy Inc. to Imperial Oil Ltd. to accelerate a shift to smaller projects. Crude oil is the country’s top export and Statistics Canada said last week companies intend to cut capital investment by 18.7 percent this year in the oil and gas, mining and quarrying category.

“The mood has been really challenging over the last four to six weeks,” said Greg Stringham, vice president of markets and oil sands at the Canadian Association of Petroleum Producers in Calgary. “The recent downturn really just has added to the concern this is going to be longer-lasting.”

Consumer Debt

Economists who predict no rate cut focus on the risk of feeding record consumer debt loads and housing prices instead of beleaguered energy and manufacturing companies.

The case for a recession is invalidated by a low unemployment rate and the bank’s measure of core prices is holding above its 2 percent target, according to Derek Holt, Scotiabank’s vice-president of economics. Canada’s jobless rate of 6.8 percent is down from 8.7 percent around the last recession in 2009.

“Employment figures on their own should almost be enough to say there wasn’t a recession,” Holt said by phone from Toronto. “Why would you abandon the second-half rebound story? It seems wildly premature to me.”

Prime Minister Stephen Harper has also touted job gains as evidence the economy is progressing ahead of an Oct. 19 election -- and he’s set a goal this year of putting the brakes on seven years of deficits. Poloz must be wary of sending a contradictory message, Holt said. “The political heat that they would take for talking down confidence in the Canadian economy is something they can’t ignore,” he said.

Realtor Warning

Tim Quinlan, an economist at Wells Fargo Securities LLC in Charlotte, North Carolina, also said a rate cut may not stimulate the right parts of the economy. “The animal spirits to engage in real capital spending just aren’t there right now,” he said. “I’m still forecasting no change but it’s almost a coin toss at this point.”

Another call to stand pat came Monday from Royal LePage, the country’s largest real estate services firm, noting strains in the market. At 163.3 percent of disposable income in the first quarter, household debt was close to the revised record 163.6 percent in the fourth quarter, Statistics Canada said on June 12.

“It seems premature to ring the recession alarm bells now, injecting further monetary stimulus,” Phil Soper, chief executive officer of both Royal LePage and its parent company, Brookfield Real Estate Services Inc., said in a report Tuesday. “The country’s all-important real estate market simply does not need a rate cut.”

Poloz’s last public comments likened the housing imbalances as a side effect of life-saving surgery. And most of the data suggesting a second quarter of falling output has come in the last two weeks, after those comments were made at a June 28 panel at the Basel-based Bank for International Settlements.

“If the doctor says you need surgery to avoid death, the side effects usually don’t deter you, you just go ahead and manage them somehow,” Poloz said. “Other issues must be subordinate and I think of them as side effects.”

Before it's here, it's on the Bloomberg Terminal. LEARN MORE