Bank of Canada strategy unfolds

03-21-2022
Bank of Canada strategy unfolds

Investment implications of rate hike

 

In response to hot inflation and high commodity prices, the Bank of Canada (BoC) decided on March 2 to raise the overnight lending rate from the effective lower bound of 0.25% to 0.5%. However, the BoC acknowledged heightened geopolitical uncertainty and said it will continue its reinvestment program, through which it will keep buying Government of Canada (GoC) bonds only to replace maturing securities, thereby keeping its overall holdings at a relatively high level for now.

Looking ahead, the Bank did take further hawkish steps in the removal of pandemic-era monetary support by preparing markets for the eventual need for quantitative tightening (QT). As a complement to interest rate hikes, the Canadian authorities will now consider exiting their reinvestment program by allowing the BoC’s bond holdings to mature, thereby reducing the balance sheet from its current high level.

How have markets reacted?

The Canadian dollar and stock market rallied in the immediate aftermath of the BoC’s first interest rate increase since September 2018. Meanwhile, GoC bonds sold off and the yield curve flattened – a trend I expect to continue as the BoC’s tightening cycle fully runs its course. For the bear flattener to potentially morph into a bull flattener, I suspect moderating output, easing supply chain disruptions, and cooling inflation would be required.

I wouldn’t want to be a policymaker in this environment of heightened geopolitical uncertainty and related energy supply shocks. If a central bank overreacts to inflationary pressures, it could restrict financial conditions, negatively impact confidence, and potentially drag down economic growth. If the monetary response is understated, it could exacerbate inflationary pressures as well as their destabilizing effect on consumption and the pace of broader economic activity.

To use a golfing metaphor, however, it seems the BoC kept it in the middle of the fairway. On one hand, Canadian policymakers gave just enough of a signal – a 25 basis point hike, but not a 50 basis point hike – to convey that the general direction of interest rates is changing from flat to up. On the other hand, the BoC stopped short of QT and refrained from allowing its GoC bond holdings to begin shrinking.

Investment implications

At the very least, I think the Canadian stock market and energy sector are interesting geopolitical hedges in this tense operating climate.

Generally speaking, my sense is that Canada does best in an environment of robust global growth, rising commodity prices, an appreciating Canadian dollar, and higher interest rates – all of which are in place now.

The following chart shows that Canadian stocks tend to do better when commodities are rising (one form of inflation), as has been the case since early 2020. While Canada is a developed country, it relies on resource extraction, so firming raw materials prices have been an important link in a chain of positive events for Canada. Simply put, I believe that what’s good for materials prices is generally good for the Canadian economy.

The bottom line is that economic growth, early-stage commodity prices (as measured by the CRB Raw Industrials Index), the loonie, and Canadian stocks have typically moved in the same direction across time. All those asset classes are “first movers” and are extremely sensitive to minute changes in the North American economic outlook, which remains relatively stable for now.

Talley Léger is Senior Investment Strategist, Invesco Thought Leadership, Invesco Canada.

Subscribe to the Invesco Canada blog.

Disclaimer

Content copyright © 2022 by Invesco Canada Ltd. Reprinted with permission.

The opinions referenced above are those of the author as of March 2, 2022. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.

The information provided is general in nature and may not be relied upon nor considered to be the rendering of tax, legal, accounting or professional advice. Readers should consult with their own accountants, lawyers and/or other professionals for advice on their specific circumstances before taking any action. The information contained herein is from sources believed to be reliable, but accuracy cannot be guaranteed.

Some references are U.S. centric and may not apply to Canada.

Commissions, management fees and expenses may all be associated with investments in mutual funds and exchange-traded funds (ETFs). Trailing commissions may be associated with investments in mutual funds. For mutual funds the indicated rates of return are the historical annual compounded total returns, including changes in share/unit value and reinvestment of all distributions, and do not take into account sales, redemption, distribution or optional charges, or income taxes payable by any investor, which would have reduced returns. For ETFs unless otherwise indicated, rates of return for periods greater than one year are historical annual compound total returns including changes in unit value and reinvestment of all distributions, and do not take into account any brokerage commissions or income taxes payable by any unitholder that would have reduced returns. Mutual funds and ETFs are not guaranteed, their values change frequently and past performance may not be repeated. There are risks involved with investing in ETFs and mutual funds. Please read the prospectus before investing. Copies are available from Invesco Canada Ltd. at invesco.ca

These are the personal views of the author as at the date indicated, and not necessarily the views of Invesco Canada. The views expressed above are based on current market conditions and are subject to change without notice; they are not intended to convey specific investment advice. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although such statements are based on assumptions considered to be reasonable, there can be no assurance that actual results will not differ materially from such expectations.

Products discussed on the Invesco Canada blog page are available to Canadian investors only.

†Invesco Fixed Income (IFI) is a unit comprising Invesco Senior Secured Management, Inc. of New York, U.S, Invesco Advisers, Inc. of Atlanta, U.S.; Invesco Asset Management Ltd. of London, U.K.; and Invesco Canada Ltd. of Toronto, Canada.