The gap between interest rates in Canada and the United States is expected to widen, but this doesn’t necessarily mean pain for the Canadian banks, argues BMO Nesbitt Burns.

The Bank of Canada has already hiked rates this year ahead of the Federal Reserve Board, and it is expected to keep hiking rates while the Fed stands pat. However, “As the Bank of Canada continues to carve out its independent tightening path, this does not spell trouble for Canadian interest-sensitive stocks,” BMO Nesbitt Burns insists.

“First, the tightening cycle is expected to be mild in 2002, especially with the Fed staying on hold — we look for the Bank to hike rates by 100 to 125 basis points from current levels by the end of the year. Second, rate-sensitive sectors tend to be driven more by long-term bond yields than by overnight policy rates.”

BMO says that there’s no discernible trend in bank stocks relative to the overall TSE during periods of Bank tightening. “Third, we do not expect a big back-up in long-term rates. Underlying inflation is expected to remain stable at around 2% in the year ahead, Ottawa’s fiscal position remains strong, and a stand-pat Fed will act as an anchor on bond yields. Finally, wider Canada/U.S. spreads should continue to support a recovery in the Canadian dollar, which could itself help attract renewed foreign investment inflows to Canadian equities.”

Banks should also benefit from economic recovery, BMO Nesbitt says. “While specific credits continue to bump up loan loss reserves, a rebound in profits will eventually help the credit cycle turn the corner.” It notes that the BMO Nesbitt Burns Financial Services Research Team expects bank loan losses to ease to $4.7 billion in 2003 from $6.6 billion this year. “Moreover, loan growth by the banks is beginning to perk up again, led by impressive gains in residential mortgage lending due to the sizzling housing market.” Mortgages now account for almost half of all chartered bank loans, it says.

“Combined with a somewhat sunnier economic outlook for Canada, the stronger credit position of domestic banks should help them continue to outperform their North American peers even with the Bank tightening independently.”