The main event for Canadian investors since our last issue was the Bank of Canada’s recent interest rate announcement and Monetary Policy Report (MPR) where it clearly laid out the case for raising rates before long. It upgraded its growth outlook for 2012 to 2.4%, implying that the slack in the economy would be eliminated sooner than previously expected. Moreover, the central bank seems more comfortable with the risks that remain. The economic environment is characterized as one in which emerging market economies achieve a soft landing, the U.S. economy grows at a steady pace and Europe emerges from its recession before long.
- Markets in Canada were reminded this past week that the other side of a stronger growth outlook is higher interest rates. The Bank of Canada’s latest rate announcement sounded a more hawkish note, and markets are now placing their bets on when rate hikes will occur.
- We anticipate the first tightening sooner rather than later. We expect the Bank to raise the overnight rate in two 25 basis-point steps in September and October of this year. However, due to the stillfragile nature of the recovery, and stronger Canadian dollar that is the likely result of higher rates, we foresee the Bank then taking a pause, before raising interest rates another 50 basis points in 2013.
- Our bond yield forecasts have been adjusted accordingly, but the bulk of the increases coming in shorter-dated issues, leaving the curve flatter overall (see page 3). We have also raised our forecast for the Canadian dollar in the near-term, reflecting the lure of higher interest rates to foreign investors.
- Beyond our borders the global economy is looking a tad brighter also, with the IMF and OECD recently upgrading their economic forecasts. The sovereign debt situation in Europe still bears close watching, as Spanish yields continue to rise. On the plus side, the risk from higher oil prices has eased recently, which should give some relief to struggling economies in the coming months.
In this benign scenario, the Bank stated “some modest withdrawal of the present considerable monetary policy stimulus may become appropriate”. We read that to mean modest and gradual rate hikes are coming this year, and we expect the Bank’s next 25 basis-point hike to come in September, followed by another 25 bps in October.
It is hard to envision a significant and extended tightening cycle, as the Bank will be sensitive to the moderate pace of economic growth, and the risks that remain both at home (household indebtedness) and abroad (Europe). Moreover, hiking rates aggressively would fuel an unwanted rally in the Canadian dollar, amplifying the impact of monetary tightening. Therefore, we expect the Bank to outline the case for a pause at its October MPR, and to wait and assess the impact of the tightening and the evolution of risks, before taking rates another 50 bps higher in two 25-point moves in the spring of 2013, followed again by a pause. This leaves Canada’s overnight rate at 2% at the end of 2013, the same target we have had for some time now, we have just moved up the timetable on the same degree of tightening.
One can quibble with exact timing. It could easily be argued that the Bank will act sooner and use the July MPR for justification. Equally, if the global economic risks intensify (with Europe being the leading candidate) it could once again change its messaging and stay on the sidelines longer. So, like any good forecast, the risks to the new base case scenario outlined above are balanced.
One implication of the earlier-than-expected rate hikes is that we have raised our Canadian dollar forecast in the near term, leaving the loonie higher in 2012 overall (see table page 4), and higher on average in 2013 as well. However, reflecting that our rate forecast end point has not changed, neither has our Canadian dollar target of 105 U.S. cents at the end of 2013. Our outlook for bond yields will also be somewhat higher this year; but, one needs to keep perspective – a half-point rise in the overnight rate will raise 10-year bond yields by about a quarter of a percentage point (see chart). This would translate into about a 30-35 basis point rise in 5-year bond yields, which would lift 5-year mortgage rates by a similar amount if sustained. A similar half point of rate hikes in the first half of 2013 would have roughly matching effects on bond yields, still leaving interest rates relatively low.
While not spelled out explicitly in the Bank of Canada’s messaging, higher interest rates would have the happy coincidence of tempering household debt growth, which is identified as “the biggest domestic risk”. Higher interest rates are poised to arrive at the same time that chartered banks are pursing tighter lending policies consistent with new regulatory guidelines, both of which will act to lower personal debt growth and dampen real estate activity. Ultimately, moving the timetable for higher interest rates forward adds to our conviction that home sales and home prices are headed for a correction in 2013.
World Markets Recalibrate Risks
Despite major economic agencies, like the IMF and the OECD upgrading their global growth outlooks recently, global equity markets are largely in the red over the past month as investors seem to be a bit more pessimistic about the outlook, taking most commodity prices lower, and government bond yields higher. One notable government bond yield that has been increasing lately is Spain’s (see chart). A recent Spanish government bond auction had good uptake, but at a higher yield as markets are becoming concerned about the new Prime Minister’s ability to get Spain’s fiscal house in order. However, there have been positive signs out of Europe, with the most recent German investor and business sentiment indicators showing increased optimism.
A big factor behind increased risk aversion in the U.S. was the disappointing payrolls report for March, after strong jobs growth in recent months had been cause for optimism among investors. But, other areas of the U.S. economy continue to exhibit positive signs. Confidence among manufacturers improved in March, and the Fed’s latest beige book painted a somewhat rosier picture. Perhaps most encouraging development in the past month, which had been flagged as a key area of concern in the beige book – rising gasoline prices – finally looks to be losing some momentum. Oil prices have been declining, with Brent crude down about $7/bbl in recent weeks. It could take some time before consumers start seeing much relief at the pumps, but it is good news that one of the major risks we had previously flagged has started to recede.
The more pessimistic mood on markets likely reflects a recalibration of the risks that still exist in the global economy, and that investors had probably gotten a little ahead of themselves in the rally seen so far this year. But from our perspective the main story has not changed. Europe is expected to recover slowly from its current recession. The U.S. economy is improving, but growth will only be moderate. In Canada, we have moved the timetable forward on interest rate hikes, but have left the end point unchanged, leaving a relatively low interest rate environment intact.