Trader’s Narrative

Today the Bank of Canada decided to maintain their historically low interest rates at 0.25% but they did sound cautiously optimistic:

Recent indicators point to the start of a global recovery from a deep, synchronous recession. Global economic and financial developments have been somewhat more favourable than expected at the time of the July Monetary Policy Report (MPR), although significant fragilities remain.

A recovery in economic activity is also under way in Canada. This resumption of growth is supported by monetary and fiscal stimulus, increased household wealth, improving financial conditions, higher commodity prices, and stronger business and consumer confidence. However, heightened volatility and persistent strength in the Canadian dollar are working to slow growth and subdue inflation pressures. The current strength in the dollar is expected, over time, to more than fully offset the favourable developments since July.

Source: Bank of Canada

Unlike Australia, who has already started ended their easing cycle, they believe that inflation is not a danger and won’t be for the foreseeable future. Not only is it being kept in check by the frail economic recovery, the annoyingly strong Canadian dollar promises to keep a lid on it, if it does creep up.

Add to that the intoxicating cocktail of a commodity based economy, a strong real estate market (see below), strong fiscal discipline, and a famed (and quite boring) political stability that rivals Switzerland and you have the makings of a love affair:

One of the main reasons for our resilience has been the health of our real estate markets. I must confess that I was surprised to see the subdued reaction of the Canadian real estate market to the crash of its US counter part. After all, the two economies are intertwined like no other two countries in the world. However, for all our inter-dependence, there are significant differences. Canadian bankers never quite got the hang of laughing in the face of infinite risk or perhaps our regulators have yet to be so completely and embarrassingly captured as they are in the US.

Whatever the root cause, the Canadian real estate market has bounced back after a very late and shallow decline. As well, while our mortgages do default, the rate is extremely low and has barely experienced an uptick worthy of note:

Source: Globe & Mail

Canadian REITs gave long term investors quite a scare late last year as they were dumped along with everything else. However, while their price may have declined, their value continued to be very attractive. When I featured RioCan (REI.un) in November 2008 it was trading at $13 Cdn and yielding 10% - since then it has risen to $18 Cdn - and that’s not even considering all those juicy monthly distributions.

Meanwhile, Canadian equities have risen 27.3% in 2009 and slightly over 50% since their spring lows. But here’s the curious thing. While most major stock markets around the world have recovered from their shallow retracement in late September and gone on to newer highs for the year, the Canadian S&P/TSX index has not. That non-confirmation is slightly unnerving, especially when you consider just how much the Canadian equity markets have going for them.

Today’s Bank of Canada rate decision is being watched very carefully. Not because of any lingering doubts about what they will do; because according to the rate futures there is a 100% expectancy of a 50 basis point cut (and a 73% chance of a 75 basis point cut).

The question on everyone’s mind is what will the six big Canadian banks do?

The last rate cut decision by the Bank of Canada resulted in a huge public relations mess for the Canadian banks because they refused to pass on the full rate cut to their customers. While the central bank lowered Canadian rates on December 9th, 2008 by 75 basis points, the banks grudgingly lowered their prime rates by only half a percentage point.

They have also refused to lower mortgage rates, citing “extraordinary credit market conditions”. This in spite of the fact that all stress measures of the credit market as well as money “costs” have fallen tremendously.

For example, the Banker’s Acceptance rate is now hovering around 1%. The 5 year bond rates are around 1.58% and the 30 year at 3.6%. Compare that to 5 year mortgage rates of approximately 6.75%-6.50% and you notice that that is a huge gap. In fact, according to historical data, Canadians have never seen such a discrepancy in their financial markets.

If the banks refuse to lower their prime rate again, the Canadian banks will not only widen the gap between the central bank rate and the “real rate” available to people but they will also negate any influence which the central bank is trying to have on the Canadian economy. In the end, by their belligerence, they could be pushing Canada into a deeper and longer recession than it would otherwise have to endure.

In that case, it would be a good idea for the usually soft-spoken governor of the Bank of Canada, Mark Carney, to call a meeting with the head of all Canadian banks and throw some chairs around.

Here’s a chart showing historical central bank rates for 7 major countries (Canada, US, ECB, Japan, England, Australia and Sweden).

UPDATE:
The Bank of Canada lowered its overnight benchmark rate by half a percentage point as expected. All Canadian banks followed by lowering their prime rate by the same amount to 3%, which means they are still 25 basis points behind the central bank’s lowering agenda.

Here is the press release:

The Bank of Canada today announced that it is lowering its target for the overnight rate by three-quarters of a percentage point to 1 1/2 per cent. The operating band for the overnight rate is correspondingly lowered, and the Bank Rate is now 1 3/4 per cent.

The outlook for the world economy has deteriorated significantly and the global recession will be broader and deeper than previously anticipated. Global financial markets remain severely strained. Measures taken by major governments are beginning to encourage credit flows, although it will take some time before conditions in financial markets normalize. In addition, a series of recently announced monetary and fiscal policy actions will also support global economic growth.

The last time the Canadian central bank cut by 3/4 percentage points was on October 23rd, 2001. They had already cut from 4% to 3.5% along with other central banks after the tragic events of September 11th. Then the Bank of Canada followed up with a cut from 3.5% to 2.75%.

Here is the updated chart for the global central bank rates:

Canada now has the second lowest rates, after the US. Or third, if you want to count Japan (but why would you?).

Speaking of monetary policy, I thought it would be interesting to look at the global central banks. Here is a chart for six of them for the past 10 years: European Central Bank (ECB), Bank of Canada, US Fed, Reserve Bank of Australia, Riksbank (Sweden), and the Bank of England (EDIT: after a request I added Japan).

Not surprisingly, they more or less move in synch with each other. Sometimes even cutting rates in quick succession to catch up with the leader. The outlier in this group is Australia. Not only did they take their rate higher than others, they also haven’t lowered it to match the others. But in the previous easing cycle (2001) they only came down to 4.25% also.

The Fed was the first central bank to lower key interest rates. The next was the Bank of Canada. The slowest among the 6 in the chart is the European Central Bank and Australia. These laggards have tried to make up for their mistake by making some incredibly deep cuts recently. I’m especially surprised by the 0.75 cut from the ECB.

The Bank of Canada will most probably deliver a 50 basis point rate cut when they meet next week, on December 9th.

Considering the swiftness of rate cuts, their global coordination, as well as their level in comparison to previous easing cycles, we are probably close to the end of the easing cycle. But, and I hate to say this, if this time is different, then who knows if history is any kind of a guide.

At this point, it is tempting to throw out all historical templates because they have done a monumentally poor job so far. While keeping in mind the danger of thinking that “this time it is different”, we are seeing signs that the world is undergoing a dramatic downturn in economic activity.

Just today, data was released showing the largest one month increase in unemployment in the US since the 1970’s - taking the unemployment rate to 6.7%. Add to that a swan dive in consumer confidence, an implosion in Detroit, melting real estate, etc.

It is safe to say that the central banks will continue to prioritize economic growth over inflation for the moment. Especially since we may very well experience a bout of deflation.

According to Jim Stack of Investech Research, there are a few conditions which must be met before a new bull market can be born. They are a mix of monetary, technical and sentiment measures. I’ve looked at four of them already:

• Consumer Sentiment
• Formal Recession
• 20%+ Decline
• Coppock Guide

Here is the fifth: monetary policy. Of course, almost every single central bank around the world has reduced interest rates. Here is a quick summary of a few key ones:

US Fed
The intended Fed funds rate stands at 1% but the problem is that the Federal Reserve took its sweet time in lowering interest rates. Rates topped out in June 2006 at 5.25% and were taken down by the Fed subsequently. But as the bond market repeatedly was warning, the Fed was behind the curve by a very wide margin.

The US is also undertaking a gargantuan multi-trillion dollar fiscal stimulus package with a much more comprehensive one waiting in the wings until January 20th 2009 when Obama takes over.

Canada
Almost one full year ago, the Canadian central bank began its easing cycle and I wrote that since central banks move in packs, this was the beginning of a world-wide trend.

The Canadian central bank has since lowered interest rates continuously. The overnight rate has almost halved from 4.5% to 2.5%. The next meeting in early December is seen by almost all as another opportunity to cut further.

China
The Chinese central bank announced a massive 108 basis point cut in their key interest rate today (to 5.58%). While this is their fourth time cutting rates since September, this recent move shows just how worried the Chinese government is. Usually interest rates are stepped up or down by just a 27 basis points but this move is four times larger in magnitude.

China has also announced a $590 billion fiscal stimulus package as well as lowering the reserve requirements for several banks to pump more money into their economy. Right now, putting money into a bank account is a losing proposition since the latest data has inflation at 4% and banks pay 2.5%. Basically, China is pushing its people to consume, rather than save.

England
The Bank of England is no stranger to large rate cuts. At the beginning of November, it cut 150 basis points off its key lending rate (from 4.5% to 3%). That followed a 50 basis point cut in early October 2008. Most are expecting another cut next week when the monetary policy committee meets. Some are even calling for a further 0.50% cut.

England is also pushing forward a VAT reduction (to 15.0%, from 17.5%), and a $30 billion stimulus package.

European Central Bank
The ECB has been the most sluggish in responding to the current decline in economic activity. They are under pressure in their next meeting of December 4th to take drastic action and lower by 50 basis points. But considering the extremely hawkish tone of the ECB that is very unlikely.

The ECB has already cut 100 basis points since October to bring their rate to 3.25%. But as the Eurozone faces its first recession in 15 years, it may not be enough.

Australia
The Reserve Bank of Australia topped up its rate in March 2008 at 7.25% and ever since has been lowering it. On October, it also cut 100 basis points and more recently, by 75 basis points to bring the target cash rate to 5.25%. This is the steepest cut in rates since the 1991 recession in Australia. And it may just help them to dodge most if not all of the fallout.

The Australian government is also implementing a stimulus package of $6.7 billion - helping first time home buyers and pensioners.

Japan
In its most recent decision, the Bank of Japan held interest rates steady at 0.3% (not a typo). They are reluctant to return to the zero interest rate policy they adopted between 2001 to 2006 because it was not that helpful. But the Japanese central bank is pursuing alternative ways of pumping money into their economy. For example by accepting a wider assortment of assets as collateral.

Warm up the helicopters!
At this point, all central banks are focused on the present battle against the very real danger of a deflationary spiral. Of course, if they overdo it, as they almost always do, then they have to quickly mop up the extra money sloshing around the world financial markets without causing another dramatic downturn.

Don’t you just love central planning comrade?