– Our interest rate outlook implies that the Bank of Canada will normalize monetary policy both later and more slowly than the US Federal Reserve.
– We expect the US Federal Reserve to start hiking rates in June 2015 versus the Bank of Canada in December 2015. We also expect the Bank of Canada to have raised rates by 175 bps by the end of 2017, compared with 275 bps from the US Federal Reserve.
– Our view that the Bank of Canada will raise rates later and slower than the Fed is due to a combination of higher private-sector leverage, a preference for a weaker currency to boost exports, and the relatively higher exposure of Canada to downside risks to the global economy.
The Bank of Canada: Later and Slower than the Fed
Our interest rate forecast implies that the Bank of Canada (“BoC”) will start to tighten policy later and slower than the US Federal Reserve (“Fed”).
We expect the Fed to start hiking rates in June 2015 versus the BoC in December 2015. We also expect the BoC to have tightened rates by 175 bps by the end of 2017, compared with 275 bps from the US Federal Reserve.
Forward interest rate markets are also pricing in that the BoC will move later and more gradually than the Fed. In fact, the recent market volatility has raised expectations for an even longer time lag. For instance, the market is now expecting just one rate hike from the Fed by the end-2015, and almost no rate hikes from the BoC thru end-2016.
In this context, we contrast the key components of the US and Canadian economies, with the objective of explaining to investors the reasons why the BoC will likely tighten later and slower than the Fed.
Our Interest Rate Outlook Is Not Due To Divergent Business Cycles or Labor Market Slack
Our view on the interest rate outlook in Canada versus the United States is not driven by a belief that the respective business cycles in both countries will diverge significantly, nor from a marked difference in the level of “neutral” rates between the two economies.
Chart 1 shows the respective levels for real gross domestic product in the US and Canada since their trough in Q2 2007. The cycles of both economies are highly aligned. The modest outperformance in growth in the Canadian economy is arguably reflective of the relative damage that the financial crisis brought to the US housing and financial sectors, and also is reflected in the higher current level of policy rates in Canada (the Canadian overnight lending rate is currently 1 per cent, compared to the US Fed Funds target rate of 0 to 0.25% per cent).
We also do not have a strong view that the ‘neutral’ (or steady-state) level of policy rates in Canada is particularly different from the US in the medium-to-long term. As Chart 2 shows, policy rates in Canada have on average been only 0.25% higher than the US (using quarterly observations) since the introduction of inflation targeting from the Bank of Canada in 1992.
Finally, the improvement since the 2007-2008 global financial crisis in the labor markets in Canada and the United States has been remarkably similar, when considered in relative terms. Although a simple comparison of the unemployment rate in both countries would clearly highlight the faster pace of US labor market recovery, our view is that this fails to consider how significantly more volatile the US labor market has been.
Rather, when we consider the relative improvement of the unemployment rate – with respect to how much of the trough-to-peak deterioration in the unemployment rate has been unwound – we find that the US and Canada are at remarkably similar points in their labor market cycle. That is, the unemployment rate has retraced approximately 60-70% of its deterioration since 2009 in both countries.
Lastly, we considered relative inflation rates between the US and Canada and found that changes in the headline year-over-year consumer price index has also been broadly similar in both Canada and the United States over the past 5 years – with further convergence in absolute inflation levels during 2014.
Three Reasons For The Bank Of Canada To Lag The Fed
Our view that the Canadian interest rate tightening cycle will lag that in the United States is therefore primarily the result of factors outside of the respective business cycles.
What, therefore, are the main driver’s behind our view that the Bank of Canada will raise rates later and slower than the Fed…?
Reason #1: Higher Interest Rate Sensitivity in Canada versus the United States
The dominant factor influencing our view is the level and duration of household debt in Canada relative to the United States. As a result, the monetary policy transmission mechanism – the impact from changes in policy rates – has a stronger effect in Canada than in the United States.
Chart 4 compares household debt as a percentage of GDP for Canada and the US from 1990 onwards. Household and non-financial corporate debt is significantly higher in Canada than in the US. The relatively high level of Canadian private-sector debt is a known cause of concern for the Bank of Canada, and rightly so. But from the perspective of monetary policy transmission, the higher level of private sector leverage also does imply a stronger impact from interest rate changes.
In addition, the average duration of Canadian household sector debt is significantly shorter than its US equivalent, primarily reflecting differences in the structure of the Canadian and US mortgage markets. In Canada, the majority of mortgages are either linked to Bank Rate directly or fixed for relatively short durations (five years is the norm). In the US, by contrast, mortgage rates are normally fixed over a longer-term horizon. Thus, changes in policy rates will affect Canadian mortgage payments either immediately – or at least sooner – than the comparable fixed rate mortgage in the US.
Reason #2: The Bank Of Canada Wants To Lag The Fed, So As To Deflate the Canadian Dollar And Support The Export Sector
Our interest rate outlook is also partly driven by the view that the BoC intentionally wants to lag the Fed in terms of its tightening cycle.
It’s important upfront to understand the current BoC Governor’s background – Stephen Poloz worked at Export Development Canada for over a decade, including as President and CEO since 2010. With the recent weakening of the Canadian Dollar, Poloz has gone to lengths to emphasize that the BoC targets inflation, not the level of the currency. We agree in principle, but as mentioned above these factors are not mutually exclusive.
We therefore find it interesting that Governor Poloz, whilst not targeting the currency specifically, has frequently made reference to concerns over growth, investment and jobs originating from the export sector. Bear in mind that the “hollowing out” of the manufacturing export sector as a result of a strong Canadian Dollar was a major criticism of the outgoing BoC Governor Mark Carney.
Our view is that Governor Poloz might not be targeting a specific level for the Canadian Dollar, but his preference for a modestly weaker currency is clear. The most effective way to weaken the currency is through a narrowing of the short-term interest rate differential between the US and Canada.
Chart 5 shows just how important US versus Canadian nominal yields are as a driver of the currency.
Governor Poloz has also made several remarks recently that support our view that the BoC would prefer a weaker currency. In late August 2014, when US rate markets were starting to more aggressively price rate hikes from the Fed, Governor Poloz labored on the independence of BoC policy, stating that “The main thing people should understand is that our policy is quite capable of being fully independent [from the United States], as it has been these past few years.” In mid-October, Governor Poloz also mentioned that he wasn’t alarmed about a situation in which the Fed’s key rate could exceed Canada’s.
Although we agree with Governor Poloz – that the BoC is not explicitly targeting a currency depreciation or level – we do think that the central bank views currency weakness in the near-term as a key tool in achieving their longer-term inflation mandate.
Reason #3: Canada Is More Exposed To A Global Slowdown Than The US
Finally, we think that the BoC is likely to lag the Fed due to the Canadian economy’s relatively higher exposure to the global economy.
We assess this very simply by looking at the share of each country’s exports to their total GDP. In the US, exports account for roughly 13% of GDP, compared to 30% of GDP for Canada.
This impact, however, has the potential to be two-sided. A stronger global economy would have a larger positive impact on Canadian growth, whilst a weaker global economy would have a larger negative impact. However, given the recent deterioration in the growth outlook in Europe and several Emerging Market countries, our view is that Canada’s larger share of exports will likely have a relatively larger “negative” impact on Canadian growth, and by inference cause the BoC to be more cautious raising policy rates than the Fed.
Additional Observations Concerning Central Bank Models
We separately considered both the BoC and Fed models for assessing the impact of changes in monetary policy. The BoC uses a quarterly projection model referred to as the Terms of Trade Economic Model, or “ToTEM”. By contrast, the Fed uses a somewhat outdated model “FRB/US” model.
Without going into the extensive limitations of such models or the longer-term implications for raising interest rates, we would just highlight that the impact of a 100 basis point move in policy rates in both central bank models are surprisingly similar in the short-term. Specifically, the BoC predicts that the impact of a 100 basis point rise in policy rates would peak after 5 quarters, at which point it would lower GDP by 0.6%. By comparison, the Fed model has an identical 0.6% impact on GDP after 4 quarters.
Interestingly, the Fed model has a larger assessment of the impact of monetary policy. We considered this in conjunction with the age of the model, which dates back to 1999. This model was therefore prior to the extensive deleveraging that occurred in the US household sector following the 2007/08 financial crisis.
As a result, although important, we would not view the respective bank models as a particularly useful factor influencing our interest rate outlook.
 The Globe And Mail 27 October 2009, “CIBC: Canada at risk of ‘hollowing out’. ”
This report contains forward-looking statements. Forward-looking statements include statements that predict future events, conditions or results – including strategy, expected performance or prospects, opportunities, risks and possible future actions. Forward-looking statements are based on current expectations and projections about future events and are inherently subject to risks, uncertainties and assumptions about the Funds and economic factors. Forward-looking statements are not guarantees of future performance, and actual events and results could differ materially from those expressed or implied in the forward-looking statements. These statements require us to make assumptions and are subject to inherent risks and uncertainties. Our predictions and other forward-looking statements may not prove to be accurate, or a number of factors could cause actual events, results, performance, etc. to differ materially from the targets, expectations, estimates or intentions. Do not place undue reliance on our forward-looking statements.