THE BANK OF CANADA (BOC) and the U.S. Federal Reserve Board appear poised to take different paths as the U.S. economic recovery strengthens and Canada’s economic recovery falters. Specifically, the Fed is expected to raise its overnight interest rate while the BoC is expected to hold steady.
The Fed, which sets the interest rate and tone for much of the U.S.’s investment-grade bond market, is expected to increase the overnight rate to 50 basis points (bps) from 25 bps in mid-December. Meanwhile, the BoC is expected to hold at the present rate of 50 bps, given Canada’s weaker economic recovery.
Canada appears a laggard in this “Fed goes first” process of raising interest rates. But, given that the Fed’s overnight rate has been at 25 bps and the BoC’s has been at 50 bps, any Fed move will, for the time being, just be convergence. What comes later is what may vex bond and foreign- exchange markets.
The Fed’s rate tightening will flatten the yield curve in the U.S., while Canada’s curve will change little – if at all. The two countries’ bond markets are poised to diverge – not so much on interest rate moves, but on interest rate expectations. The Fed’s expected move means accommodative monetary policy is finished in anticipation of economic recovery and subsequent rising inflation. The U.S. is leading, and Canada is destined to follow in 2017 or 2018.
The U.S.’s economic recovery is underway and Canada’s gross domestic product (GDP) may rise by the 2.2% consensus in 2017, but dramatic improvement in Canadian GDP growth to 2.7% for 2017 would be required for the BoC to follow the Fed’s lead, says Chris Kresic, senior partner and head of fixed-income with Jarislowsky Fraser Ltd. in Toronto.
The consequences of what can be seen as a change in interest rate momentum in the U.S. vs interest rate equalization when the U.S. and Canadian interest rates match would be a slight strengthening of the greenback and a modest weakening of the loonie by 5%-10%, Kresic suggests.
A move of 25 bps in the U.S. interest rate is a harbinger of what’s to come. A report from New York-based Goldman Sachs Group Inc. suggests bond investors could face massive losses as the long-awaited interest rate normalization begins. Goldman Sachs predicts a US$1.1-trillion drop in the value of bonds listed on the Bloomberg Barclays U.S. aggregate index.
That’s a massive loss that would mark the end of the 34-year long-bond bull that began when then-Fed chairman Paul Volcker raised interest rates in 1982 to break the back of inflation. The interest rate rise would be the end of the party and hit long government bonds especially hard.
As of mid-October, the average duration of the Bloomberg Barclays U.S. aggregate index was 6.1 years, up from 6.6 years at the start of the year. The higher duration indicates investors played interest rate weakness by adding risk. Now, it’s time to pay the piper.
There will more losses because the Bloomberg Barclays U.S. aggregate index includes investment-grade bonds only. It excludes non-investment-grade debt, mortgages and bank loans to corporations.
The effect of interest rate increases on negative-yield bonds has been startling. The world’s inventory of bonds, which pay less at redemption than at issue and are estimated to be US$10.4 trillion by Bloomberg LP, dropped by 13% in the first two weeks of October. If that seems shocking, consider that the total market value of negative-yield government debt, top-level corporate and asset-backed bonds rose to US$12.2 trillion in July 2015 from US$3.3 billion in July 2014. That’s a thousandfold increase.
For now, Canada’s bond market is insulated from the repricing underway in the U.S. market. The Fed could minimize the reversal of this trend by raising interest rates in increments of 10 bps, Kresic notes. The BoC eventually will follow the historical tradition and raise interest rates.
For now, if the Fed raises interest rates to 50 bps, that will be only at the existing BoC rate. That’s no reason for Canadian bond investors to panic, says Edward Jong, vice president and head of fixed-income with TriDelta Investment Counsel Inc. in Toronto.
The question of when the BoC will begin raising interest rates comes down to what happens to Canada’s GDP. On the downside, expectations are low, albeit firming, for energy prices and stagnant growth in non-energy exports. In addition, the rebuilding of Fort McMurray, Alta., is going slowly; there are political worries about international trade treaties that seem increasingly unpopular in Europe and perhaps in the U.S.; and the great unknown, at the time of writing, is how a new administration in Washington, D.C., will handle trade issues in a political climate favouring protectionism.
For Canada’s interest rates, the worst may not be so bad at all. U.S. political uncertainty comes on top of Brexit and expectations that Italy may leave the European Union and take several weak banks with it. Money may move from troubled Europe-based banks and scandal-plagued U.S. banks to the relative calm of Canada’s bond market, boosting bond prices and lowering market rates.
Canadian interest rates have remained positive throughout despite the trend to negative interest rates in Switzerland, Japan and, from time to time, Germany. Thus, the BoC can, reasonably, do nothing until there’s strong recovery in energy prices in Western Canada and in manufacturing in Central Canada, suggests Charles Marleau, president and senior portfolio manager with Palos Management Inc. in Montreal.
“We recommend that fixed- income investors position themselves in five- to 10-year bond exchange-traded funds,” he adds, “and stay short on any fixed-term debt.”
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