The collapse in oil prices in the second half of 2014 provoked a surprise rate cut from the Bank of Canada at the start of this year. Six months later, the prolonged downdraft in crude spurred another reduction in the overnight rate to 0.5 percent amid back-to-back quarters of economic contraction.
But as oil prices (in Canadian dollars) have been tumbling since early November, the yield on the one-year Government of Canada bill has continued to inch higher to 0.549 percent:
The last time the front-month West Texas Intermediate contract was trading around these levels, the Canadian one-year yielded just 0.365 percent
Investment in Canada's oil patch was a key driver of aggregate growth in capital spending across the nation that enabled Canada to bounce back from the financial crisis faster than most other advanced economies. The unwinding of the shale boom, however, has also taken investment in the Alberta oil sands down with it and resulted in the loss of more than 25,000 jobs in resource extraction over the past year through November.
On Monday morning, overnight index swaps suggested that a rate hike at the Bank of Canada's March 2016 meeting was just as likely as a cut at 4.3 percent apiece, despite the central bank's insistence that the economy is undergoing "a complex and lengthy adjustment" in response to the enduring decline in oil prices.
In some respects, this divorce between Canadian short rates and oil prices can be attributed to better economic data. After all, during the quarter in which front-month West Texas Intermediate futures had hit their lowest level of the year (until Monday!), the Canadian economy expanded at a faster rate than the U.S. The oil-driven downturn, the market seemed to be saying, has passed.
Bank of America Merrill Lynch Economist Emanuella Enenajor, however, notes that even outside the resource-related softness, growth has been trending downwards:
"Clearly, weakness in the energy sector is spilling over into other sectors," she wrote. "Looking ahead, the broadening economic drag from low energy prices should restrain growth and keep the BoC on hold, although risks of an ease are rising,"
On the other hand, the lack of aggressive pricing of rate cuts may reflect the notion that monetary stimulus can't do much more to cushion the blow of a terms-of-trade shock.
"I think Bank of Canada recognizes that the overnight rate, which exerts a lot of control on the one-year yield, is of limited use at this point in fighting low oil prices," said James Price, director of investment services at Richardson GMP. "Insofar as the economic malaise spreads east as a result, perhaps they'll keep an easing bias but I do not think they ease unless employment starts getting worse in Ontario and Quebec causing broader economic softness."
Price expects the one-year yield to trade relatively flat over the next six to 12 months.
Among other economists who aren't forecasting an additional rate cut from the Bank of Canada, like CIBC World Markets Chief Economist Avery Shenfeld, the risks to the one-year yield are tilted to the downside.
"Right now putting a bet on a Bank of Canada cut is fairly attractive in the sense that you don’t lose much if they don’t cut, but win big if they do," said Shenfeld. "You're right that it wouldn't take a huge surprise in economic activity to prompt a rate cut."