TD Bank economists predict that the Bank of Canada is likely to remain on hold next week, and that its next move is likely to be a hike, not a cut.

A few weeks ago, TD says, markets were expecting the Bank to hike rates in September, with the risk lying towards more than one additional rate hike. However, following recent credit market turmoil, markets are now expecting the central bank to remain on hold next week, with about a 75% chance of a rate cut priced in before the end of the year.

“While we think that talk of rate cuts is overblown, we do agree with the markets insofar as we expect the Bank of Canada to remain on hold at next week’s [meeting],” it says. “However, contrary to the markets, we believe that the next move by the Bank of Canada will be a rate hike, not a rate cut, and the only issue is the timing.”

TD says that while, “the U.S. sub-prime market woes should not have any direct impact on the Canadian economy, since Canada has a perfectly healthy housing market and a minimal sub-prime market, fear and contagion are powerful beasts, and they have led to a re-pricing of risk in Canada and across the globe.”

“The problem is that the financial instruments backed by sub-prime mortgages became so sophisticated that trying to find out who holds the riskiest of assets is like looking for a needle in a haystack. And, given the past inappropriate lending behaviour of many U.S. firms, it is problematic to assess the future delinquency rates on the loans,” it explains. “This has led to immense difficulty in pricing assets that have any probability of containing sub-prime mortgage holdings, which has snowballed from a widening of credit spreads into a stark reduction of liquidity in certain corners of the money market, as investors flock into risk-free assets.”

Apart from this turmoil, the case for a rate hike is there, TD says. It points out that inflation is above the Bank’s target, the economy is operating above its capacity limits, and economic growth has been robust over the last couple of quarters. “However, the recent volatility in financial markets has put a dent in the optimistic economic outlook,” it observes.

That should give the Bank reason to pause from its rate hiking, however, TD says it will ultimately resume raising rates. “The timing of the next rate hike will depend entirely on how the economy evolves over the next several weeks. Although there is a risk that credit markets will deteriorate further, we think the more likely scenario is that short-term borrowing conditions in Canada improve, as more information becomes available about who is exposed to the U.S. sub-prime market,” it says. “What we do know for certain is that it would take a significant slowdown in Canadian economic growth before the Bank of Canada would even contemplate cutting rates, since the economy is in a situation of excess demand, so market expectations for a rate cut before the end of the year are clearly overdone.”