Bond traders pushed up Canada's two- and five-year federal bond interest rates to 1.49% and 1.69%, respectively, on Sept. 8, two days after the Bank of Canada [BoC] raised its overnight interest rate to 1% from 0.75%. The market reaction put Canadian interest rates ahead of U.S. treasuries for the same periods by 21 basis points (bps) and five bps, respectively.
This rise marks the first time since October 2014 that Canadian interest rates exceed U.S. interest rates. For now, Canada is the sweet spot in North American debt markets - with higher interest rates to come, according to a Thomson Reuters Corp. poll of bank economists conducted in the first week of September.
The immediate cause of the jump in Canadian interest rates was data released by Statistics Canada on Sept. 8 that indicates the labour market in Canada is bullish, with the longest run of employment gains since the 2008 global market collapse. Canada added 22,200 jobs in August, the ninth straight monthly gain and more than market expectations, for a rise by 15,000. As well, average hourly wages grew by 1.8%, the highest rate since October 2016.
What the StatsCan numbers don't show is a change in the political environment. Market expectations for cuts in U.S. corporate taxes have dimmed. Absent major reductions in social spending in the beleaguered U.S. national health-care program, tax rates in that country are not likely to drop. As well, there now is massive hurricane damage that will require federal spending. North Korea's nuclear ambitions and bomb tests add risk to U.S. capital markets.
Canada now seems to be a reasonable haven for money - give or take some tax issues that are minor from the perspective of foreign investors who recently pushed the Canadian dollar (C$) as high as US82.55¢. That level was US3¢ higher than the market has estimated for purchasing power parity, notes Charles Marleau, president and senior portfolio Manager for Palos Management Inc. in Montreal: "The increase in the value of the Canadian dollar, usually a stop sign for the export sensitivity of the BoC, evidently has lost some of its weight in BoC decision-making."
With Canadian and U.S. central banks' overnight interest rates now equal, at 1%, winning the tug of war between the two countries's rates depends on the damage the hurricanes have inflicted, the dollar value of which will be mildly inflationary for the U.S. economy as demand for building products soars.
Longer term, there are likely to be lower inflation prospects for the U.S. and flattening of its yield curve, plus strength in the Canadian economy if energy prices revive, says Edward Jong, vice president, fixed- income, with TriDelta Investment Counsel Inc. in Toronto.
The damage caused by multiple hurricanes will have short-term impacts on equities and debt markets, he says, adding: "The [U.S. Federal Reserve Board] probably was going to raise [interest rates] in October, but is likely to postpone that until December. Meanwhile, the Bank of Canada may raise [interest rates] once more by the end of the year."
The rise of the C$ against its U.S. counterpart - a consequence of stronger domestic growth and the BoC's September interest rate hike - has to be viewed in the context of other currencies. The C$ has not appreciated against the euro and is mostly flat except relative to the U.S. dollar (US$).
Looking ahead, the question is where interest rates will head in 2018. Jong's opinion: "Five per cent for the 10-year Government of Canada bond is history. We won't see that again."
The Fed is likely to resume rate rises, says Chris Kresic, senior partner and head of fixed-income with Jarislowsky Fraser Ltd. in Toronto: "The hurricane season is a reason for the Fed not to raise [rates]. But when that is past, the Fed is likely to resume raising short rates."
By October 2018, short interest rates in Canada could rise to 1.5% at most, and U.S. rates are likely to match that level, Kresic says, adding that the recent 2.06% rate for U.S. 10-year treasuries could rise to 3% by that date, and the rate for 10-year Canadas rise to 2.5%.
The view out to 10 years leaves out the "Trump Effect." In other words, significant budget uncertainty, wildly volatile politics and North Korea's nuclear weapons tests. Absent those issues, the more important factor is inflation. Based on current annualized consumer price index growth of 1.9% in the U.S. and 1.7% in Canada, U.S. 10-year treasuries are likely to surpass interest rates on 10-year Canadas in the decade ahead.
The final issue is the BoC's sensitivity to the C$/US$ exchange rate. If the price of a barrel of crude oil shoots up above US$55 - benchmark light sweet crude is at US$48 at time of writing - then the loonie would appreciate, Marleau adds. That would imply the BoC would hold interest rates as the Fed raises them, which would cause the loonie to sink.
Near-term interest rate decisions ultimately could be made by investors concerned that U.S. President Donald Trump will not achieve his goal to lower taxes steeply. Indeed, stocks have backtracked since midsummer as markets have become increasingly pessimistic about the outlook for lower U.S. tax rates.
For now, it seems the BoC is neither a currency hawk nor a growth dove. And bond markets are on hold, with Canadian and U.S. overnight interest rates convergent.
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