This Wednesday, the Bank of Canada has a decision to make.
Canada’s oil “dream” is dying thanks to the inexorable slide in crude prices and as the IEA made clear earlier today, the pain is set to persist for the foreseeable future as the world “drowns in oversupply.”
“Lower for longer” has hit the country’s oil patch hard. We’ve spent quite a bit of time documenting the plight of Alberta, where job cuts tied to crude’s slide have led directly to rising suicide rates, soaring property crime, and increased food bank usage (not to mention booming business for repo men).
Adding insult to injury for Canadians is the plunging loonie. Because the country imports most of its fresh fruits and vegetables, the weak currency has triggered a sharp increase in the price of many items in the grocery aisle as documented in a hilarious series of tweets by incredulous Canadian shoppers.
The question for the Bank of Canada is this: is the risk of an even weaker loonie worth taking if a rate cut has the potential to head off the myriad risks facing the economy?
We’ll find out what the BOC thinks tomorrow, but in the meantime, analysts have weighed in. JP Morgan’s Daniel Hui says CAD needs to fall further lest producers should simply close up shop. "[W]ith West Canada Select (WCS) now sitting just a dollar above the average per-barrel operational cost of $20 (Canadian), the risk is that any further decline will cause a whole new host of spillovers including potential shutdown and retrenchment of energy extraction and exports (with its attendant growth and balance of payment effects) or the potential of highly leveraged companies running operational losses, and the more contagious financial impact that might have in Canada, with broader spillovers."
None of those outcomes are particularly palatable. If the loonie continues to plunge however, it would act as a kind of shock absorber (producers’ costs are predominantly in CAD terms whereas the crude they sell is obviously denominated in USD), keeping CAD-denominated prices above the marginal cost of production.
"One of the few scenarios that would keep bitumen producers above marginal cost amid a further decline in global energy prices, is for CAD to depreciate substantially and at a much higher beta to oil price than has been the case in the past 18 months," Hui adds, driving the point home.
But this is a Catch-22. The BOC can cut and drive the loonie even lower thus allowing zombie producers to keep pumping and thus prevent still more oil patch job losses, but a falling CAD may have undesirable knock-on effects, like reduced consumer spending, for instance. Additionally, if uneconomic producers keep drilling and pumping, they’re just digging their own grave by contributing to an already oversupplied global market.
In short: there’s no “right” answer. “Economists are united in one view, that new plunges in oil prices, in the Canadian dollar, and weaker global financial conditions, make the Bank of Canada's policy interest rate decision Wednesday a very close call,” MNI writes.
"We now are looking for a rate cut next week," Bank of Montreal Chief Economist Douglas Porter told Market News. "We believe that the balance of weight has slightly tipped in favor of them going" for a rate cut, he added, pointing out that the market is pricing in a 50-50 chance of a BOC action this week.
Royal Bank of Canada assistant chief economist Paul Ferley, doesn’t agree. "We think that Governor (Stephen) Poloz will maintain his confidence that growth in exports will counter weakening business investment and he will hold the rate steady," he says.
Perhaps, but as we noted early last month, the BOC has already hinted that Europe’s not-so-grand experiment in the Keynesian Twilight Zone known as NIRP may be about to cross the pond. “The effective lower bound for policy rates is around -0.5%,” governor Stephen Poloz said in December, setting the stage for negative rates in Canada.
For their part, IceCap Asset Management says NIRP is a virtual certainty for the BOC. Here’s IceCap’s straightforward, bullet point roadmap for Canadian monetary policy:
Canadian economy to be in recession in 2016
Bank of Canada will be at 0% interest rates in 2016
Bank of Canada will be at NEGATIVE interest rates in later 2016
Bank of Canada will be PRINTING MONEY in later 2016
Ahead of Wednesday’s decision, Barclays is out with a preview and sure enough, NIRP makes a cameo.
“The BoC would need to cut at least 50bp this year to partially counteract the continued slide in crude oil prices,” the bank begins, adding that although the price of Western Canadian Select (WCS) has fallen by half since the publication of the BoC’s last Monetary Policy Report, “this has been only partially offset by the 8% nominal multilateral depreciation of the CAD.”
To fully offset the effect on GDP, Barclays says “the BoC would need to cut policy rates by at least 50bp in 2016.”
Yes, by “at least” 50bps, and that’s assuming oil prices don’t plunge further.
Of course 50bps puts the BOC at zero, so when Barclays says “at least”, they mean NIRP is likely on the way. To wit:
The central bank has room to act even if rates hit zero. A 50bp cut in 2016 would bring the overnight rate to zero. The experience of countries like Switzerland, Sweden, Denmark and the euro area has taught central banks that zero is not the lower bound. The BoC estimates that the effective lower bound for Canada could be around -50bp, giving room for further cuts if needed. Without the immediate worry of hitting the effective lower bound, the central bank might be more willing to ease sooner rather than later.
There you have it. Of course it's difficult to see how 100bps of theoretical policy flexibility will be enough to keep the shut-ins from starting in the oil patch especially considering there's only a CAD1 cushion above the marginal cost of production and considering the outlook for oil prices is particularly bleak now that 500,000 b/d of new Iranian supply are coming to market.
As for what the BOC does in the event Poloz hits the lower bound of -0.50% and the loonie still needs to weaken to offset the ill effects of declining crude, we'll leave you with one indelible image that should serve as a harbinger of what's to come...