Bank of Canada makes history—again

The Bank of Canada (BoC) has added to its already historic suite of facilities with three key actions:¹

1. Cut interest rates to 0.25%, a level the central bank calls the effective lower bound
2. Launched a Commercial Paper Purchase Program (CPPP)
3. Announced plans to purchase CAD$5 billion worth of government securities a week, which looks like a quantitative easing (QE) program, even if the central bank chose not to label it as such. Either way, this is a first for the BoC.

These policy actions follow a long list of previously announced facilities, including expanded term repo facilities, bond buybacks, and the purchasing of mortgage bonds, banker’s acceptances, and money market instruments, among other tools.

Note that the Canadian federal government also announced two significant policies on the same day:

1.  Wage subsidies for small and medium-sized businesses will rise to 75% from 10%, backdated to March 15.
2. Small businesses will receive a CAD$40,000 interest-free loan for a year, where the first CAD$10,000 is forgivable. 

In our view, these two policies should help reduce the number of job losses and provide some cushion to the expected coming economic contraction in Q2. From a markets perspective, while we continue to see further weakness in the Canadian dollar, we believe it could remain in the 1.40 to 1.45 range against the U.S. dollar for the time being. Crucially, we expect the Canadian yield curve to steepen, with monetary policy pinning down the front end of the curve and the continued expansion of fiscal policy to help lift rates at the long end.

1. The BoC isn’t targeting growth, it’s trying to restore the healthy functioning of Canadian financial markets
   
   We’ve said it before—global central bank actions at play right now aren’t intended to prevent recessions, their goal is to calm financial markets, particularly credit markets. The BoC’s statement spent a lot of time emphasizing this: “The intent of our decision today is to support the financial system in its central role of providing credit in the economy, and to lay the foundation for the economy’s return to normalcy.”¹
   
   On this front, we think the Canadian central bank is a little behind the U.S. Federal Reserve (Fed): Several risky and nonrisky spreads have widened recently in spite of the BoC’s existing facilities. U.S. spreads, on the other hand, have calmed over the past week,² thanks to the Fed’s announcement last week to support the U.S. credit market.
   
   We believe the BoC’s announcement will be effective at helping to thaw Canada’s rates markets, although implementation will be important. The U.S. experience also suggests that some fine-tuning will be necessary. We’ll know within a week whether these programs will be successful. 
   
   
2. We’re unlikely to get negative interest rates in Canada anytime soon
   
   Interestingly, the BoC described the current interest rate (25bps) as the effective lower bound.¹ When asked if Canada could see negative rates, BoC Governor Stephen Poloz said that while these were theoretically in its toolbox, research undertaken by the BoC since 2015 has shown that negative interest rates could have “significant negative impacts” on the financial system.³ Given that the BoC’s primary focus is to restore functionality to the financial markets, negative interest rates are, in Governor Poloz’s words, “not sensible.”³ His remarks are consistent with our view that the BoC isn’t considering negative interest rates as a policy tool and will instead pursue other options to support the economy. 
   
   One caveat to this view is that we still don’t know who the next BoC governor will be (Mr. Poloz’s term ends in June this year),⁴ and new leadership may take the bank in a different direction. 
   
   
3. Whether it’s formally called QE or not-QE, we’re going to have it for a long time, which could change the shape of the yield curve in Canada
   
   For the first time, the BoC will “begin acquiring Government of Canada securities in the secondary market. Purchases will begin with a minimum of $5 billion per week, across the yield curve.”¹ However many ways we look at it, the announcement still sounds a lot like QE. His argument was that the program isn’t about nudging interest rates lower, but achieving “price clearing”³ and restoring functionality to Canada’s fixed-income market. 
   
   Interestingly, similar to the Fed’s and the European Central Bank’s QE program, the BoC’s “not-QE” has no end date. The BoC’s statement says the program “will be adjusted as conditions warrant” and will continue “until the economic recovery is well under way.”¹ This last sentence is significant because it’s essentially forward guidance, a tool that Governor Poloz has long eschewed. In our mind, this is a bigger step for the BoC than it may seem on the surface. Crucially, we believe the program will suppress the front end of the yield curve and, along with ongoing expansive fiscal policy, will be supportive of a steeper Canadian curve.
   
   
4. We believe there will be more easing to come 
   
   Interest rates are at their effective lower bound, but that doesn’t mean the BoC is out of ammunition.  We’re expecting the following additional forms of stimulus in the days ahead:
   
   Yield curve control—Deputy Governor Carolyn Wilkins mentioned this during the webcast, which we believe will be introduced in both Canada and the United States. This could lower interest rates further, most likely at the front end.
   
   The BoC is likely to expand its not-QE program—This is highlighted by the central bank’s statement, which stated that the program would be adjusted as “conditions warrant.”¹ The BoC could not only change the size of its weekly purchase but also the types of securities it buys, depending on where it sees stress in the market.
   
   Credit easing—outright purchases of corporate bonds—is also possible—The deputy governor also made a nod to this tool in her comments.
   
   Financing for lending programs—Funding provided to financial institutions with the condition that it’s passed on to businesses and consumers is also possible.
   
   
5. The economic downturn in Canada could be harder and longer than the United States, but the country’s fiscal policy is now far more appropriately targeted
   
   We believe the Canadian economy is entering into this downturn in a weaker state than its U.S. counterpart because of high household debt, weak business investment (lower oil prices are certainly not helping), and an overlevered housing market. In our view, the Canadian economy will take longer to recover, and the downturn may be more severe. 
   

However, we’re confident that the federal government’s announcement of 75% wage subsidies for small and medium-sized businesses will help support the labor market; crucially, we believe the most important type of fiscal policy at this juncture is one that helps stave off job losses. In our view, these kinds of policies will allow for a less pronounced recession and, at the margin, a faster recovery.

1 “Bank of Canada lowers overnight rate target to ¼ percent,” Bank of Canada, March 27, 2020. 2 Bloomberg, March 26, 2020. 3 “COVID-19 actions: press conference (webcasts)—March 2020,” Bank of Canada, March 27, 2020. 4 “Bank of Canada Governor Stephen S. Poloz to step down in June 2020,” Bank of Canada, December 6, 2019.