The world's biggest fund managers are warning money-market traders "not so fast" on the Bank of Canada.
After two consecutive interest-rate hikes, participants in the markets for overnight index swaps and bankers' acceptance contracts are betting policy makers are set to tighten for a third time this year. Pacific Investment Management Co. and BlackRock Inc. disagree. Both say central bank Governor Stephen Poloz is on hold until at least 2018 and anticipate a more gradual approach to monetary policy.
Swaps traders are pricing in more than a 60-per-cent chance of at least one more quarter-point rate increase by the BoC's December meeting. While those odds have slid in recent weeks amid words of caution from Mr. Poloz that there is no predetermined path for policy tightening, they still stand about 10 percentage points above the market-implied probability ahead of last month's hike.
Pimco and BlackRock say uncertainty surrounding North American free-trade agreement negotiations, muted inflation and an anticipated slowdown in growth once fiscal stimulus wanes make it unlikely the central bank will raise rates again by year-end. Should they prove correct, the implications extend beyond the front end. Speculators have boosted wagers on Canadian dollar strength to the most in almost five years, just months after amassing record short positions against the currency.
"Markets just went from one end of the spectrum to the other end of the spectrum and now the bank is trying to recalibrate them to a more balanced outlook," said Aubrey Basdeo, head of Canadian fixed income at BlackRock, the world's largest money manager. The Bank of Canada "seemed in a hurry to try and remove the emergency cuts, and they didn't articulate that," he said, referencing the 50 basis points worth of reductions in the overnight lending rate in 2015. (A basis point is 1/100th of a percentage point.)
Mr. Basdeo said policy makers are probably willing to let the economy run hot for the time being to combat the lack of private investment that's been a defining characteristic of Canada's recovery. "Without doing anything with monetary policy, you can allow the supply side of the economy to catch up with the demand side, while inflation is still quiescent," he said. "If inflation were an issue, then clearly the bank would be moving."
While Canadian growth has outpaced that of its southern neighbour, coming in above 3 per cent year-over-year since March, inflation remains muted. Consumer price inflation dropped below 2 per cent year-over-year in the first quarter, and has stayed there since.
"We don't really yet see the economy becoming more broadened and self-sustaining in terms of business investment and exports," said Ed Devlin, head of Canadian portfolio management at Pimco. "The combination of a strong currency and the NAFTA renegotiations will hurt that."
The loonie has climbed 7.6 per cent against the U.S. dollar this year. Canada sends more than 70 per cent of its exports to the United States. Growth will probably slow to closer to 2 per cent in the next 12 months, Mr. Devlin said, and in a scenario in which the U.S. Federal Reserve raises rates two to three more times next year, he expects the Bank of Canada might do so once or twice.
Mr. Devlin said he's underweight the front-end of the U.S. bond curve because it's underpricing the pace of Fed policy tightening to come, whereas he's overweight the front-end of the Canadian curve and has a "small" short Canadian-dollar position relative to the greenback.
The BoC's next interest-rate decision is Oct. 25, during which the Monetary Policy Report containing economic projections is also expected to be released, and Mr. Poloz will follow with a news conference. Of the 16 economists surveyed thus far by Bloomberg, a dozen expect the bank to keep the overnight lending rate unchanged at 1 per cent, while four see another 25-basis-point increase.
Canada's September jobs report, due on Friday, is likely to influence rate-hike expectations. Economists surveyed by Bloomberg are expecting a gain of 12,000 jobs, slightly more than half of what was seen in August.
"The bottom line is that there's such a wide range of outcomes right now," said David Rosenberg, chief economist and strategist at Gluskin Sheff + Associates. "Whatever base-case forecast you have for the Canadian economy, the probability curve is a lot wider than usual. That's really what Stephen Poloz discussed: There's a lot of uncertainty and no shortage of downside risks."