If the BOC understands that the situation in Canada does not yet warrant creating new money, we can see a further reduction in the Target for the Overnight Rate, which currently is 50bps. Another option would be to reduce assets. But the assets to dispose of would be government debt, and its respective yield would rise. This would push interest rates higher and increase the demand for/appreciate the Canadian dollar.
We are closer to the 21st of April, when market participants expect the Bank of Canada (BOC) to provide more definition on its future policy. In the past two days, I have observed that, along with the appreciation of the Canadian dollar, there is a lower expectation of an aggressive move by the BOC. The Canadian dollar has appreciated from 0.815 USD cents to 0.8222 cents, as I write. Personally, I see this trend more related to USD weakness than to Canadian dollar fundamentals.
For the BOC, Canadian dollars in circulation are a liability (and an asset for their holders). If the BOC decides that the situation in Canada is so weak that indeed warrants the creation of new money (i.e. an increase in liabilities), we need to see a matching increase in the assets of the BOC. What assets would increase? The BOC, in its annual report, shows two main categories of assets: a) Securities purchased under resale agreements and b) Investments, which are comprised of Treasury bills of Canada and Government of Canada bonds. The BOC could potentially use any combination of these. But I think it would make more sense to directly buy securities from those institutions in need of liquidity (category a, Advances to members of Canadian Payments Association account).
If the BOC understands that the situation in Canada does not yet warrant creating new money, we can see a further reduction in the Target for the Overnight Rate, which currently is 50bps. Another option would be to reduce assets. But the assets to dispose of would be government debt, and its respective yield would rise. This would push interest rates higher and increase the demand for/appreciate the Canadian dollar. Both consequences are counterproductive.
So far, this is a summarized description of a mechanism, that does not tell much by itself. More relevant, I think, is to understand the purpose behind the creation of new money, particularly in Canada. Canada’s ongoing crisis was imported. Canadian real estate prices did not trigger a negative wealth effect, as in the United States. The transmission mechanism was different, and originated as a slowdown in production, mainly related to exports. Canada did not have a “balance sheet” problem, but will have an “income” one (which can obviously later develop into a serious balance sheet problem). Under these circumstances, I think the only way to revert this situation is with either deflation, which is politically unacceptable, or an increase in productivity. Creating new money avoids deflation, of course, which denies us access to one of the solutions. Therefore, do we have to think that creating new money will increase productivity? Why is Canada considering monetary policy to solve a productivity problem?
The reason Canada could start using the monetary approach may be the pressure coming from other nations that seek a coordinated inflationary action to offset their own deflations. This coordinated debasement of the world’s most important currencies is currently associated with “globalization”. The reason Canada is not considering a fiscal approach may be the late political instability, given that the country has a minority Government.
My only hope is that on April 21st, I read news about a lower target for the overnight rate… If I don’t, I will know we are in trouble when I start seeing the credit default swap for Canada being quoted. As I said in previous comments, sovereign credit default swaps are used to hedge the ongoing transfer of risk from the private sector to the public sector. No such transfer has occurred yet in Canada (which is the reason I think Canada’s credit default swap is not demanded yet), but the creation of new money under the mechanism described above would bring about this transfer. With it, we would also see increasing weakness in the Canadian dollar…
On another note, I think that yesterday we saw a pause in the ongoing inflationary process (also known as bear market rally). With negative news on US retail sales and the continued heavy Treasurys ($7.3BN) purchases by the Fed, suddenly, Treasury Bay seemed a safer place to dock the ships. There is an increasing and understandable concern about the effectiveness of the Fed in decreasing interest rates with its purchases of Treasurys and,… there is also an increasing expectation that the Fed will announce an upsize of the $300BN purchase program, just as I have been speculating since the March 19th announcement. This could indicate that we are at the dawn of a “run” against the U.S. Treasury.
Finally, I think the markets have not paid enough attention to the news that Poland may obtain a $20.5BN line of credit from the IMF. This is positive (in the short term at least) news, given the horrible picture in Eastern Europe and Baltic nations, and the corresponding challenge to the Eurozone.