Capital Ideas^™

Will the Bank of Canada (BoC) succeed or fail?

That’s the question being asked by economists, analysts and investors as the BoC prepares to break from its G7 peers and embark on a real-time economic experiment to engineer a smooth exit from emergency levels of pandemic monetary stimulus.

“All eyes are on the BoC,” says Tom Reithinger, fixed income portfolio manager on Capitals Express Investments Canadian Core Plus Fixed Income Fund^TM (Canada).

Canada was the first G7 nation to start scaling back government weekly debt purchases — tapering — in April 2021. The BoC then announced at its October meeting that starting November 1 it will only purchase government bonds to replace maturing ones. The bank also jumped forward the timing of an interest rate increase, as it expects a full economic recovery sooner than previously expected. The bank had forecast a full recovery for the second half of 2022 and said it would keep rates at current levels until then. Now, the bank expects a full recovery and excess economic slack to be absorbed by mid-year.

“The Bank of Canada was undoubtably hawkish in their October statement,” says Reithinger, adding that he expects the bank to lift its benchmark interest rate from 0.25% in the first quarter of 2022, just ahead of hitting a full mid-year recovery. If the rate hike comes to pass in advance of another G7 country doing so, Canada would set an example for other central bankers who will have to journey down this path sooner or later.

Inflation upside risk

According to Reithinger, the bank is now worried about inflation upside risk as the Canadian Consumer Price Index (CPI) hit a near-20-year high in October. This explains their willingness to be more aggressive in this rate-hiking cycle than through years 2017 to 2018.

“There’s no doubt in my mind the bank will be nimble and respond to the next few months of inflation outcomes, which the Governor reinforced in the press conference,” he says.

Among the data outcomes the bank will be watching will be CPI core measures, which strip out the most volatile components in the index, and not just the headline all-in total CPI number. 

Core measures have spiked with CPI-trim at 3.3%, CPI-median at 2.9% and CPI-common at 1.8% year-over-year. The last time total CPI inflation rose above the bank’s 1%-3% target range — May 2011 — all three core measures were at or below 2%. Within 10 months, total CPI, or so-called headline inflation, retreated and fell below target. But unlike 10 years ago, core inflation indicators are now telegraphing inflation.  

Inflationary signals

Core inflation measures aside, Reithinger is studying data points in the bank’s quarterly Business Outlook Survey, released the same day as the October monetary policy meeting. The survey polls a cross-section of business leaders across Canada, from about 100 firms.

One of the key dimensions Reithinger is watching is a gauge of investment spending plans among firms on machinery and equipment and whether companies anticipate spending more, less or about the same as they did over the last 12 months.

Open wallets

In response to this question, business leaders overwhelmingly said they plan to invest more. What’s eye-catching is the number of companies with higher spending plans —an all-time high over the past 20-plus years.

“The third-quarter BoC Business Outlook Survey showed the highest capital expenditure plans since the beginning of the survey,” says Reithinger, who continues, “Higher capital expenditure signals that businesses are confident in future growth, which tends to be inflationary.”

Another key survey gauge for Reithinger is expectations for wage growth. Again, firms anticipate the biggest jump in wage growth since the survey began more than two decades ago. 

“Faster wage growth tends to feed into overall inflation with a lag during steady periods of economic growth. Hence, I expect the wage effects to be felt in Canadian inflation during 2022 and 2023. Again, this signals that higher inflation is more persistent rather than transitory in the next few years,” he says.

Investment implications

Before making portfolio adjustments, investors should remember that sustained periods of elevated inflation are rare in Canadian history. People of a certain age will remember the ultra-high inflation of the 1970s and early 1980s. But in hindsight, it’s clear that was a unique period. In fact, deflationary pressures have often been more difficult to tame, as students of the Great Depression will attest.

More recently, in the aftermath of the 2007–2009 global financial crisis, inflation has struggled to hit 2% on a sustained basis. And that’s despite unprecedented stimulus measures engineered by a wide range of central bankers in North America, the eurozone and Japan.

Inflation extremes

Another important point: It’s mostly at the extremes — when inflation is 6% or above — that financial assets tend to struggle. Stocks have also come under pressure when inflation goes negative, as one would expect.

For investors, some inflation can be a good thing as evidenced by the performance of U.S. stocks and bonds. Even during times of higher inflation, both asset classes have generally provided solid returns as shown in the chart below.

An active approach

An active approach to fixed income investing is key, says Reithinger, as is the flexibility of the mandate to invest in a range of debt in Canada and around the world. Most recently, the Canadian Core Plus Fixed Income mandate reduced exposure to developed-market bonds while increasing exposure to emerging markets and inflation-linked debt. Portfolio duration stood at 7.5 years as of September 30, 2021 — lower than the mandate’s FTSE Canada Universe Bond Index benchmark of 8.1 years. Higher duration is typically associated with higher interest rate risk.   

All of which brings us back to the question at hand: will the BoC succeed or fail to engineer a smooth exit out of pandemic emergency monetary stimulus?

“The BoC is treading a thin line between reigning in higher inflation and stopping the economic recovery, the outcome of which is still very much uncertain,” says Reithinger.

And after a potential first-half 2022 rate hike?

“My view is that the bank will be cautious over the next two years to allow the economic recovery to continue but it all depends on how successful the BoC was at engineering a smooth exit in the first place.”