The Canadian Dollar: Retail Sales Suggest BoC's Mission is Complete

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The Canadian Dollar ceded ground to a stronger Pound on Friday after retail sales disappointed the markets and cast a fresh cloud of uncertainty over the outlook for Bank of Canada (BoC) interest rate policy and what is still 2020's highest-yielding major currency. 

Canadian retail sales did not rise at all in December, Statistics Canada revealed on Friday, when markets were looking for a 0.1% increase. Core retail sales, on the other hand, rose by a strong 0.5%, above the 0.4% consensus and came alongside a 30 basis point upward revision to the 0.2% declared for November. 

"The last retail sales report of 2019 showed grey skies were still hanging over the Canadian economy. It’s true there were a few rays of sunshine able to peak through, with gains outside some of the more volatile sectors and an upward revision to sales in the prior month. But the latest numbers do little to change the overall narrative that Canadian households won’t be supporting the economy to the extent they have," says Royce Mendes of CIBC Capital Markets. 

The two different sales measures suggest Canadians were happy to splurge on low value items ahead of the festive holidays although they also show that a year-long trend of aversion toward larger purchases continued in December.  

Above: Pound-to-Canadian Dollar rate rises as 2-year Canadian government bond yield (red line) falls. 15 minute intervals.  

Canada's Dollar was quoted lower against six of nine major rivals following the releaes but that performance came amid steep coronavirus-related losses for oil prices and equity markets which have obscured the investors' take on the data. Oil is Canada's largest export and for this reason the Loonie often displays a positive correlation with stock markets.

"The Bank of Canada has been holding its fire with respect to a rate cut in the hopes that the data will rebound. And, while there were a few indications that households might be opening their wallets again for some purchases, the effects of the coronavirus and rail blockades likely mean first quarter GDP will undershoot prior expectations," says Mendes, an economist at CIBC.

The BoC took the idea of further rate hikes off the table in 2019 and repeatedly expressed a range of concerns that could have eventually prompted it to cut the cash rate, although the benchmark has actually been left on hold at 1.75% since October 2018. And throughout multiple bouts of uncertainty about the outlook for Canada's economy, the ongoing resilience of domestic inflation pressure was a big driver of the BoC's many decisions to leave rates unchanged. 

Coupled with wage increases that reached post-crisis highs in 2019, those inflation pressures could have made the justification of rate cuts difficult in a counterfactual situation where borrowing costs had actually been reduced for companies and consumers, because critics could have argued that lowering the cash rate was a dereliction of the bank's inflation-targeting duty. Both headline and core consumer price indices have spent more time at or above the 2% target in the last year than they have beneath it.

Above: Canadian wage growth and labour market indicators from 2010 onward. Source: Bank of Canada.  

With spending power on the up, the BoC's critics could easily have suggested that rate cuts risked inciting a sustained upward deviation from the inflation target although that case was all but washed away on Friday when Statistics Canada figures showed that retail spending barely grew at all last year. And such a development could easily turn from a vindication of the BoC's inflation-fighting decisions into an argument in favour of a 2020 rate cut to 1.5%. 

"Sale volumes in December were up just 0.1% from a year prior," says Nathan Janzen of RBC Capital Markets. "There are legitimate questions about how accurately retail sales are really capturing consumer spending trends...Still, consumer spending growth has, at the least, under-performed stronger labour market conditions, and resilient consumer confidence."

Interest rate changes are often said to take up to two years to be felt in the real economy and Janzen says the BoC's hikes, which took the cash rate from 0.5% in May 2017 to 1.75% by October 2018, at least partly explain both the paltry increase in 2019 spending as well as the modest uptick in household insolvencies last year. In other words rate hikes have nipped a rip-roaring economy, which had risked the inflation target, right in the bud and the inflation-fighting part of the BoC's mission may now be complete.

However, battling against rising inflation is just one half of a symmetric obligation, with the other half seeing the BoC charged with using monetary policy to actually lift inflation in instances where the economic outlook threatens to pull the consumer price index below the target on a sustained basis. That's not happened yet and much about the outlook depends on the BoC's own reading of the tea leaves but Friday's data may be an early warning of greater bank concerns about the consumer being in the pipeline.

Above: Canadian consumer price index from December 1993 with inflation target bands marked. Source: Bank of Canada.  

The BoC said itself in January that it'll be watching households closely in the months ahead and basing its rate decisions substantially upon its interpretation of the outlook for Canadian consumer spending.

The housing market and business investment have also both been flagged by the bank as among Canada's three "sources of economic resilience," although the outlook for all three is increasingly uncertain and at a time when the Canadian Dollar is unprepared for a rate cut. 

"Borrowing rates have since pulled back again, which could ease some near-term pressure on households. But overall economic growth will also likely be weighed down early in 2020 by another bout of transitory disruptions, in this case potential spillovers from the COVID-19 outbreak in China and ongoing disruptions to rail transportation. We think the Bank of Canada will ultimately look through most of those transitory disruptions, but underlying growth trends have also been softer, and we continue to pencil in a rate cut from the central bank in April," says Janzen, a senior economist at RBC. 

Pricing in the overnight-index-swap market implied on Friday, an April 15 cash rate of 1.63% at the BoC, which suggests investors see the odds of a rate cut at that meeting as being very much 50/50. This poses both upside and downside risks for the Canadian Dollar over the coming months. 

BoC rate policy made the Canadian Dollar the developed world's highest yielding and best performing currency for 2019 and it's remained a significant source of support for the Loonie thus far in 2020. 

Above: Pound-to-Canadian Dollar rate shown at daily intervals.