BoC Monetary Policy Monitor

HIGHLIGHTS

• Economic conditions in Canada confirm a well entrenched recession.
• Rates are nearing rock bottom, but given the severity of the economic contraction plus signals from the BoC, there is a case for a last rate cut of 25 bps to leave the overnight rate at 0.25%. The April 21 meeting, therefore, is likely to mark the end of the easing cycle.
• Aside from the decision itself, the contours of the statement will be key for providing some context. From this point forward, the focus will turn to the unorthodox policy measures.
• And while the Bank of Canada has not been shy about discussing the possibility of using non traditional monetary policy measures, such as quantitative easing, they have been coy about providing any clues as to the timing or the products that it would involve. We do not believe that such policy measures will be implemented immediately, though we expect significant detail in the accompanying MPR.

As the second quarter of 2009 progresses, the Canadian data continues to reveal an economy that is unwinding at a rather alarming pace. On both a domestic and external front, the drivers of growth appear to have seized up and there is a confluence of evidence that spare capacity is building in most industries. As such, the already weak inflation expectations that were apparent in the first quarter have deteriorated even further. In addition, the credit crunch remains a theme, though perhaps not as dire as at the beginning of the year.

These two ongoing themes - the further contraction of the economy plus the unresolved constraints in the credit markets remain the key drivers for our call for one last 25bps rate cut to the overnight rate, to put it at a new historical low of 0.25%. This is also what the market is pricing.

In truth, we are not sure that another ease is worthwhile at this time, because even though the economy warrants it, there are some technical complications that transpire when the overnight rate gets too close to zero and these arguably negate the benefit from further easing. But the BoC hinted at this possibility at the last meeting, when it noted that “the target for the overnight rate can be expected to remain at this level [0.5%] or lower at least until there are clear signs that excess supply in the economy is being taken up.” As a result, we take our cue from them.

When Life Gives you Lemons ...

The old adage about making lemonade out of life's lemons offers a useful lesson for considering monetary policy. The unrelenting stream of weaker than expected data suggests few, if any sectors have been spared the wrath of recession. With such a confluence of weak economic data, there is scope for the Bank to make lemonade (ie. ease further) out of the lemons.

And there are a lot of lemons. The weakness in the Canadian economy stems from both domestic factors and the U.S. The global economic slump has impacted commodity prices which add an additional layer of complexity to Canada's troubles.

On the domestic front, though some of the data has been better than expected, it is nothing more than a temporary rebound off significant low levels. Housing market indicators such as building permits remain soft, and the one month 13.7% M/M blip higher in housing starts for March seems to be more of an anomaly rather than a reversal of the prior six month string of monthly contractions in activity. There is no doubt that the loss of 272.9K jobs since the beginning of the year has played a pivotal role in scaling back spending, especially on big ticket items like housing. About the only good news to take away from the deterioration in housing is that it is highly unlikely that the slump will underpin a U.S. style mortgage market implosion thanks in large part to the more conservative lending standards in Canada, as well as the relative lack of financial innovation in mortgage products. But it is not only housing activity that has suffered. Retail activity has been under pressure, notwithstanding the 1.9% M/M expansion in January, as consumer fundamentals remain constrained. The best example of just how constrained consumers are is the 8% unemployment rate in Canada for March, which is the highest since 2002. With a peak-to-trough expectation of a loss of more than half a million jobs, the domestic side of the Canadian economy still has many hurdles to conquer and is unlikely to return to the black until early 2010.

But the external drivers are surely more worrisome. The U.S. economy continues to languish in recession, and while there have been modest improvements in some of the economic data, it is not sufficient to suggest anything other than a stabilization in the pace of deterioration. The Canadian economy has felt the impact of the contraction in its largest trading partner. In the three months to February, the trade balance has been in deficit for two of the three months. And the deterioration in demand for Canadian exports has been broad based. Both commodities, especially energy and autos have seen a massive reversal in demand.

The retrenchment in consumer and business activity, which is made worse by the downturn in commodity prices, has underpinned a lot of excess supply. Consumers no longer have the wherewithal to bid prices higher. Headline CPI has been below the Bank of Canada's 2% target since November 2008 and was most recently just 1.2% Y/Y in March.

Businesses do not have much pricing power either and as such, their margins are experiencing massive compression. At 74.7% in the fourth quarter, capacity utilization rates are at historical lows. Perhaps more concerning is the rise in the percentage of businesses that expect inflation to be below 1%. That number rose to 41% in Q1 from 30% in Q4, suggesting that the mounting economic slack is truly taking hold of inflation expectations. That will surely not come as good news for the Bank of Canada.

Lending Improves at a Glacial Pace

Since the last FAD, there have been a number of indicators that suggest a small modicum of improvement in credit conditions and lending.

The most recent data from the Bank of Canada's quarterly Senior Loan Offer Survey for Q1 2009 showed a small improvement in lending conditions as compared to the fourth quarter, but the overall tone in business lending was still clearly constrained. The overall balance of opinion on lending conditions fell from 76% in Q4 to 60% in Q1, this is a big advance but given that a number over 50 reflects tight credit conditions, it is really more of a second derivative improvement rather than a first order one. It is encouraging that much of the improvement arose from nonpricing conditions. This is good news because it means that lending is improving due to an improvement in the terms of borrowing including issues related to capital allocation and collateral. In short, banks seem to be easing up on the demands made to give loans. By contrast, the pricing component of business lending conditions remained roughly flat, suggesting that interest rates were not helping lending.

On the consumer side, conditions remain a bit strained, though it is difficult to get a true grasp on the issue since the available data is rather lagged. Consumer credit was still up 7.7% Y/Y in January, but that was well off its peak of 11% Y/Y in late 2007. But perhaps a more proximate indication of just how recent rate cuts have helped consumers is via mortgage rates. The standard 5-yr fixed mortgage rate fell 64bps in the first quarter, which has improved affordability to be sure. But despite these small steps toward a healthier credit market, the underlying tone still indicates bottlenecks in credit markets remain.

Good Till the Last Drop

With all the evidence that the Canadian economy has unwound at an exceptionally rapid pace, there is now a better case for one last 25bps rate cut than there was at the last FAD. In fact, at the March 3 FAD the Bank admitted that “indicators of aggregate demand point to a sharper decline in Canadian economic activity and a larger output gap through the first half of 2009 than projected in January.” This ultimately forced the Bank to revise their macro economic forecasts for 2009.

As such, the argument for a last top up in monetary easing has a good deal of support. Given the downward revisions to GDP and the fact that there is more downside risk to the outlook than upside risk, the Bank is likely to put as much monetary stimulus in the pipeline as possible. An overnight rate of 0.25% is the lowest possible but could still create some disturbance in other financial products. As such, there is the possibility that the Bank narrows the 50bps range that currently exists around the overnight rate so spread products can still be positively priced. In any event, Canada will surely be in good company with such a wafer thin central bank rate. The U.S, U.K., Japan and Switzerland all have official rates hovering around 0.0% but in all cases have stopped short of an actual 0.0% central bank rate.

Not Necessarily Out of Bullets

With the end of the traditional easing cycle rapidly approaching, the focus will increasingly turn to if and when the Bank of Canada decides to use alternative monetary policy. Thus, from here on in, there will be an even greater importance on the statements and the rhetoric coming out of Bank officials.

We are inclined to think that the Bank of Canada will eventually engage in quantitative easing though it is unlikely to do so immediately. Comments as recently as April 1 from Bank of Canada Governor Carney certainly suggest that the Bank has explored the tools that would allow for alternative policy measures to be used. Given the tenor of the Bank of Canada's Senior Loan Officer's Survey, should credit conditions deteriorate further in the near term, the Bank might be compelled to finally dust off the printing presses.

Should the Bank embark on quantitative easing, the most likely target would be the purchase of government bonds, following the example of other G7 countries that have embarked on a QE path. Other credit products, such as ABCP or corporate bonds certainly remain on the table, but in our mind they would only be used in a deeply distressed situation (even more so than currently). This is because there have been definite signs of recovery in the corporate bond market since issuance has improved and deals are coming to fruition.

A Positive vs Normative View of Policy

Finally, to put all of this in perspective, there is some room to quibble about positive and normative economics at this point. Positive economic relates to 'what is' and what is likely to happen is a 25bps rate cut. The downward momentum in the data argues for it. Taking a normative economics or 'what should be' approach yields a slightly different result in our mind.

By pushing rates even lower than the current 0.5% the Bank risks creating complications with regard to the pricing of spread products. This may outweigh the upside of even lower rates. Money market funds could experience a lot of trouble as they would be forced to reduce their management fees, which might force some out of business and/ or cause investors to flee money market funds as their returns fall. The secondary implication is for money market issuers who would have far more trouble securing demand for their product. That in turn, could impinge on an important source of funding for short term borrowers.

Moreover, it creates difficulties for the Bank of Canada's role as an intermediary, as a 0.25% overnight rate would push the rate on excess reserves down to 0.0%. In this scenario, excess reserves could no longer offer any rate of return which could create frictions between commercial banks to lend their excess reserves to the central bank. This is more of a tail risk but certainly one worth keeping in mind.

Even so, we are willing to bet that the Bank errs on the side of the positive rather than the normative and certainly has the backing of the futures market.

TD Bank Financial Group

The information contained in this report has been prepared for the information of our customers by TD Bank Financial Group. The information has been drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does TD Bank Financial Group assume any responsibility or liability.