BOC Cuts 25 Bps and Introduces Unconventional Policy

 
BOC Will Maintain Rates at 0.25% Until End of Q2 2010

The Canadian dollar finds itself on the defensive this morning following the Bank of Canada's decision to cut its key overnight target rate by 25 basis points to 0.25%. By committing to hold the current policy rate until the end of the second quarter of 2010 (assuming inflation doesn't begin to build), the Bank has effectively stated that rates have been cut to rock bottom, and that every effort will be made to keep them there for more than a year. This dovish policy view, combined with a rather dismal outlook for both the Canadian and global economies, has sent the loonie more than a cent lower, with USDCAD challenging but failing to break through the 1.25-mark on its initial run higher this morning.

In its accompanying statement, the Bank declared that "the global recession has become more synchronous" since its last Monetary Policy Report Update in January, while economic activity has continued to decline in all of the world's major economies. Further, the Bank stated that "while more aggressive monetary and fiscal policy actions are underway across the G20, measures to stabilize the global financial system have taken longer than expected to enact." With this in mind, the BOC slashed its forecasts for Canadian economic growth to show a 3.0% decline in GDP for 2009, with no sign of a recovery until the fourth quarter. Though economic growth is expected to turn positive in 2010, the Bank predicts that the nation won't hit full capacity production levels until the third quarter of 2011. The key point here for currency market participants is that all of this doom and gloom is coming from what has been, up until this point, one of the more optimistic central banks in the world amongst major trading nations. The fact that the Bank of Canada's outlook has suddenly turned so negative will cast a shadow not only on the loonie and its commodity-linked cousins in Australia and New Zealand, but all risk-sensitive currencies, such as the pound sterling and many leading emerging markets, such as Brazil, India and Russia.

Though the fact that the BOC cut its target by 25 basis points shouldn't be taken as a surprise (the market was split between calls for 25 and no change), the decision to formally freeze the benchmark target for more than a year certainly should. In explicitly stating that it expects to hold rates at the current level for an extended period, the Bank is, more than anything, attempting to manage the far end of the yield curve. It is doing so by reducing expectations of a V-shaped pattern for interest rates, with the hope being that the curve will begin to flatten, or, at the very least, not steepen materially from a rise in long-term interest rates. With inflation now expected to trough at -0.8% in the third quarter of this year, long-term inflation expectations are certainly moderating, as the significant policy measures to this point have not delivered the expected impact to consumer and producer prices. From a currency valuation perspective, today's actions certainly won't be interpreted as being positive for the loonie in the short-term, though should the Bank's aggressive policy actions help shorten the economic downturn, the long-term prospects for the loonie could very well turn up after the initial sell-off.

Risk Aversion Remains in Full Force

The USD once again finds itself well supported today with a moderate gain of 0.2% for the USD index amid the continued equity downturn in Asian and European markets. The Hang Seng finished the session nearly three percent lower than where it began the day, while the Nikkei suffered a similar fate with a 2.39% decline. Europe's major bourses were lower as well, with FTSE in London, CAC in Paris, and DAX in Frankfurt all trading between -1.2% and -1.5% heading into the close. North American equity markets are set for a lower opening as well, and commodities are failing to find a firm footing at the same time (the CRB index is 0.35% lower on the day). Crude oil is testing the $44.50-mark to the downside, providing further impetus for traders to get short on the loonie on the day.

The EUR is still trading with a 1.29 handle despite the fact that the expectations component of the ZEW economic survey came in at 13.0, well above the market's consensus expectations of a 2.0 reading. As might be expected, the current situation readings failed to inspire confidence, declining modestly from what was expected and thereby acting as an anchor on the common currency on the day. With the EUR unable to make much headway in recent sessions, it may not be long before the market's overall sentiment begins to sour amid the implementation of quantitative easing measures in the EZ, dragging the common currency lower in the intermediate-term.

The pound continued to shed value overnight, driven lower by its heightened sensitivity to market risk appetite as well as comments from a BOE official that stated that the sell-off in the pound has been justified "in some sense." That lone comment was more than enough to send sterling tumbling into the mid-1.44 area before it found its sea legs to once again trade with a 1.45 handle on firmer than expected CPI readings for the month of March.

The Riksbank in Sweden elected to cut its target rate by 50, as opposed to 75, basis points overnight, taking its benchmark target down to a near bottom level of 0.50%. Though the bank fell short of announcing further QE measures at this juncture, it left considerable wiggle room for the future by stating that there is a possibility of resorting to "other measures" should the domestic outlook continue to weaken. The SEK has rallied moderately on the slightly more-hawkish-than-expected outcome.

The AUD has continued to come under pressure from falling commodity prices and tepid risk appetite despite the fact that the RBA's anxiously awaited board minutes from its April 7th meeting showed very little appetite either for further rate cuts or for the introduction of QE measures on the part of policy makers Down Under. Though the Aussie economy is perhaps one of the most strongly positioned to come out of the global downturn amongst the first wave of recovering nations, currency traders continue to discount Oz's future performance in selling the currency forward.

Mark Frey, VP FX Trading
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