While the rate hiking cycles in both Canada and the U.S. are expected to come to close soon, and to eventually start declining, a new report says that rates will likely settle at a higher level than markets are used to — a conclusion that has implications for all sorts of assets.
In a new report, BMO Economics said that it expects rates to start coming off their current highs in 2024, ultimately settling in the 2.5% to 3.0% range in Canada, and a bit higher than that in the U.S. — leaving long-term rates higher than in recent years.
“Moderately higher trend inflation and a larger risk premium point to higher rates than over the past decade,” it said.
According to the report, inflation was exceptionally low in the years leading up to the pandemic due to the impact of globalization and emerging markets joining the global economy, which boosted the global labour force and helped keep inflation low — enabling central banks to keep rates low too.
“That highly favourable backdrop for low inflation is gone, with the world unlikely to find another massive increase in labour supply, as well as rising geopolitical tensions, and the trend toward friendshoring. Layer on the cost of decarbonization, and it’s easy to see why inflation could trend at least modestly higher than pre-pandemic norms, especially for goods,” it said.
In turn, higher-than-normal rates for the long term will have implications for housing markets and financial assets, the report said.
“With yields expected to settle in at a higher level than pre-pandemic trends (let alone the extreme lows during the depths of 2020), we don’t expect much headroom for home prices over the medium term,” the report said.
At the same time, in financial markets, “almost all asset prices are readjusting to the new rate reality,” the report noted.
Against a backdrop of higher Treasury yields, “even with last year’s market damage, the new rate backdrop does not leave relative equity valuations as particularly cheap,” it concluded.
“Most markets have precious little risk premium built in at the moment, and are potentially vulnerable to any negative surprises, whether it’s on the inflation/rate front or on the growth outlook (perhaps due to a geopolitical shock),” it added.