The Financial institution of Canada is betting on micro fee cuts when lockdowns weigh in

© Reuters. FILE PHOTO: A sign is pictured outside the Bank of Canada building in Ottawa

By Fergal Smith

TORONTO (Reuters) – Money markets see an increased chance the Bank of Canada will cut interest rates closer to zero as tightening economic restrictions to contain a second wave of COVID-19 cases offsets optimism that the Activity will recover later this year.

Interest rates in Canada were believed to have bottomed out after falling 150 basis points to a record low of 0.25% last March, a level that the Bank of Canada considered an effective floor. But in November, Governor Tiff Macklem said a lower floor could allow Canada’s central bank to relax further if the economy slows.

Data from Friday showed Canada cut jobs in December for the first time in eight months. Economists braced for another weakness in January after vaccine rollouts began to slow and some provinces move to tighter lockdowns.

The BoC, due to make a policy decision next week, has ruled out negative rates, so further easing would likely mean a so-called “micro rate cut” of less than 25 basis points. This is an increase the central bank has not used since the overnight rate target became its main policy tool in February 1996.

“The fact that the Bank of Canada has kept the door open (a rate cut) for the past few months has not gone unnoticed by the markets,” said Andrew Kelvin, chief strategist for Canada at TD Securities.

“People have their watch,” although it is not clear that more incentives are needed, added Kelvin.

Due to the risk of lower interest rates, Canada’s three-month overnight index swap rate has moved below the 0.2% level at which the overnight rate stabilized. It has fallen by 4 basis points since November and is trading at around 0.17%.

A BoC spokeswoman declined to comment, referring to a lock-up period before next week’s interest rate decision.

Other central banks have moved in small steps. In November, the Reserve Bank of Australia cut its key interest rate 15 basis points to 0.1%, while the Bank of England did so last March.

“If you think 25 basis points is not the effective floor then why wouldn’t you move rates to the effective floor because we have continuous quantitative easing and we are still buying provincial bonds,” Kelvin said.

A rate cut could provide additional impetus by reinforcing already low borrowing costs and examining further gains for the Canadian dollar.

Adjusting the asset purchase program and setting yield curve targets are other easing options announced by the BoC, given the risk of economic scars if the recovery takes too long.

Economic activity is expected to pick up again once the lockdowns end and vaccinations continue to spread. However, analysts say the potential for another rate cut should not be ignored.

“The Bank of Canada, which only mentions this in prepared comments, means they are considering it,” said Royce Mendes, senior economist at CIBC Capital Markets.

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