QE3 and the Loonie

By David Dittman • September 17, 2012 • Canadian Edge Weekly

About two weeks ago, on Sept. 5, the Bank of Canada (BoC) maintained its target overnight interest rate at 1 percent, the level it’s held through 16 consecutive meetings, or about two years. The last move the BoC made to its benchmark rate was to raise it by 25 basis points, or 0.25 percent, to 1 percent at its Sept. 10, 2010 meeting.

In its statement announcing the decision the BoC and Governor Mark Carney kept the language it’s been using for months now to indicate its bias is in favor of a rate increase: “To the extent that the economic expansion continues and the current excess supply in the economy is gradually absorbed, some modest withdrawal of the present considerable monetary policy stimulus may become appropriate.”

The problem for the BoC is that although the domestic economy is operating at close to its potential circumstances beyond Canadian borders are far from ideal. This fact is reflected most obviously with the decision by the Federal Open Market Committee (FOMC) of the US Federal Reserve to engage in a third round of quantitative easing (QE3), continue its “Operation Twist” and to extend its commitment to keeping rates low through 2015.

Central bank bond purchases in the US will continue until the domestic economy begins to grow at a pace sufficient to absorb the currently unemployed as well as new entrants to the jobs market. It is an open-ended commitment in terms of the amount of bond purchases as well as the length of time such measures will persist.

The Fed’s move to buy more mortgage-backed securities, to continue its program of buying long-dated Treasuries and selling shorter-term paper already on its balance sheet and to extend its promise to keep rates low until 2015 was well received if you base your judgment exclusively on the action in global equities markets on Friday, Sept. 14.

For Mark Carney, who has said the BoC’s rate decisions will reflect domestic conditions but has also conceded that there are limits to how much the Canadian central bank can diverge from the Fed, the Fed’s move is another complicating factor as attempts to maintain Canadian inflation within the mandated range at around 2 percent for the medium term.

As the BoC noted in its Sept. 5 statement, although the economic recovery in the US continuing only at a “gradual pace,” Europe is in recession and China is “decelerating,” “prices for oil and other commodities produced by Canada have, on average, increased since July.”

Continuing low rates also make it more difficult for Mr. Carney to combat what he sees as a rising consumer debt problem among the Canadian population. Slow US and global growth have dragged on Canadian exports–the trade deficit ballooned to a record high in July–and consumption is slowing, as Canadians seem to be hearing warnings about high household debt.

But Canada’s trade surplus with what’s still its most important trade partner, the US, shrank to its smallest level in nearly two years. The strong loonie, which makes it more difficult for exporters to compete south of the border, is probably part of this problem.

Overall both exports and imports fell, a development that may ease the upward pressure Mr. Carney is feeling. In its July Monetary Policy Report the BoC identified weakening demand for Canadian exports as one of the downside risks to its economic forecast. The July trade data provide it a reasonable way out of its current hawkish stance. The BoC’s current projection is for exports to remain below their pre-recession peak until the beginning of 2014, so even this news isn’t entirely out of step with expectations.

Things have calmed a bit today, as markets had likely priced in the potential for more Fed stimulus during August and early September. Fed Chairman Ben Bernanke, as is his wont, telegraphed a big move during his annual appearance at the Reserve Bank of Kansas City Economic Symposium in Jackson Hole, Wyoming, on Aug. 31.

Equally likely is that the reality of slowing growth in developing Asia, particularly China, coupled with the fact that non-traditional monetary policy has to this point been unable to solve what remains a persistent inability of the US economy to create meaningful growth in the number of good-paying jobs, is overcoming the Fed’s announcement.

The Canadian dollar has backed off from the 2012 closing high of USD1.0326 it established Sept. 13, the day of the Fed’s QE3 decision. North American equity indexes are flat to marginally negative as of this writing, and European bourses are uniformly in the red. Asian markets, however, led by Japan’s Nikkei and including Hong Kong’s Hang Seng Index and the S&P/Australian Securities Exchange 200 Index, closed in positive territory on Monday.

A strengthening loonie is generally a headwind for exporters but a tailwind for importers. It has positive wealth effects for Canadians generally but hurts manufacturers in particular. Canada remains the strongest economy among the Group of Seven and is home to one of the healthiest federal fiscal situations on the planet.

Fundamentals, based on long-term growth in demand for commodities rooted in the emergence of developing Asian economies, should remain strong for years.

QE3 and other non-traditional monetary policymaking in other parts of the world, including Europe and Japan, coupled with the dire fiscal situations facing the majority of developed-world governments, will make the loonie look good in comparison.

Over the past 10 years the Canadian dollar has surged from around USD0.63 to USD1.03, appreciation of more than 60 percent. This rapid rise has been largely due to the strength of the economy in Great White North, which has in abundance what the rest of the world needs more and more of: commodities such as oil, basic materials and agriculture.

Canada also has one of the world’s strongest banking systems, and its federal government, under the charge of politicians both right and left on the political spectrum, put together a decade’s worth of balanced budgets spanning the mid-1990s up to the onset of the Great Recession.

The loonie looks particularly good relative to its southern neighbor. The US economy, although it’s still better than most, is not healthy. Federal, state and local governments are deep in debt. And the Fed’s non-traditional monetary policy will result in a weaker dollar.

Canada is in relatively good shape. But that doesn’t mean Mr. Carney and his colleagues at the BoC have an easy time of it.

The BoC will make its next scheduled overnight rate target announcement on Oct. 23, 2012. It will release its third (of four for the year) Monetary Policy Report the following day.

The Roundup

Here’s where to find second-quarter earnings analysis and outlook for all Canadian Edge Portfolio Holdings as well. The only company not yet reporting is Student Transportation Inc (TSX: STB, NSDQ: STB), which is on a different reporting schedule. The company will release its fiscal 2012 fourth-quarter and full-year (ended Jun. 30) results in late September.

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