The Bank of Canada’s Next Move and Its Potential Impact on Canadian Bonds
Author: David Stonehouse
November 22, 2019
The Bank of Canada (BoC) has been standing pat on interest rates for more than a year, but that may be set to change if the U.S. Federal Reserve and other central banks around the world continue to ease in the months ahead.
In fact, it may have no other choice than to start cutting rates in unison with its global counterparts, giving investors in Canadian government bonds a potential advantage going forward.
The BoC ‘s decision to leave its key lending rate steady since October 2018—while other central banks have been cutting—has been based on several good reasons including a higher inflation rate than in the U.S., strong employment and ongoing concerns about the negative impact lower rates could have on the country’s already substantial consumer debt.
The same reasoning, however, can no longer be applied without taking into consideration some of the other economic factors now at play in determining where Canadian interest rates could be headed.
For instance, the U.S. inflation rate is starting to catch up to Canada’s and U.S. deficit spending is expected to outpace that in Canada, especially heading into a U.S. election year.
At the same time, Canada’s energy sector continues to struggle, and the country’s newly-elected minority government may not have the ability to boost the Canadian economy (and therefore inflation) as much as it would were it to have won another majority mandate.
Furthermore, ongoing trade headwinds would likely affect Canada more than the U.S., given the former’s higher reliance on exports. Even a trade truce may not help much given concerns in sectors such as agriculture, energy and autos.
Finally, the BoC took the unusual step of mentioning Canadian dollar strength during its last policy meeting, something it has generally been reluctant to comment on. Its tolerance for further strength from here seems limited.
Given this backdrop, the Bank of Canada finds itself in a dubious position. Its policy rate is currently the highest in the developed world, according to Bloomberg data, and with potential risks to the economy looming, it seems untenable for the central bank to stand aside much longer—especially if the Fed cuts further than it already has this year. At the very least, the Bank of Canada may have no choice but to match the U.S. central bank’s next few moves.
That, in turn, could have positive implications for Canadian bonds that have already been impacted by the divergent stances taken by both Canada and the U.S. regarding interest rates. More to the point, over the course of the past year, the yield on a 10-year government bond issued in Canada went from 85 basis points below its U.S. equivalent to just 20 basis points more recently. Meanwhile, the Canadian yield curve has also been inverted longer and more deeply than in the U.S.
All of this suggests that Canadian bond yields should either rise less than U.S. yields if the recent rising trend continues or fall more than U.S. yields if the reverse is true. Either way, the Bank of Canada is unlikely to pursue a more hawkish stance than its U.S. counterpart any more, and Canadian bonds seem like a solid opportunity relative to the U.S. from here.
David Stonehouse is a Senior Vice-President and Head of North American and Specialty Investments at AGF Investments Inc.
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