May 2010
How far, how fast?
An upgraded outlook for the Canadian economy this year, with real growth of roughly 3 per cent including a brisk first half, has made the resumption of interest rate hikes this summer appear to be an odds-on bet. So, now the issue for investors isn’t when, but how far and how fast the Bank of Canada will go.
There’s only one argument we can see for a steep climb in interest rates, namely, that rates are starting from record low levels, leaving a lot of work to do to return to even neutral yields. It’s indeed likely that at some point overnight rates in the coming cycle will be back to at least 4 per cent. But against that one dimensional case for a rapid run-up are many more good reasons why the Bank of Canada should, and will, opt to break it to us gently in terms of the pace of rate hikes ahead.
First, there’s the fact that the U.S. Federal Reserve remains on hold for an “extended period” that could stretch into early 2011. Pushing the Canada-U.S. rate spread too wide risks sending the Canadian dollar to record heights and crushing manufacturing in the process. And if the Fed isn’t in a hurry, maybe that tells us something about the risks that Bernanke and his team still see in the global outlook.
Second, there’s still a decent cushion against inflation from a still-high unemployment rate and lots of idle capacity, as well as from the dampening impact of a strong Loonie on import prices.
Finally, there are other forces that will help take the place of rate hikes in moderating growth and preventing an inflationary overheating. Both a 2011 tightening of fiscal policy in Canada and abroad, and sterner global regulations on bank capital and leverage, will create economic headwinds next year. Record levels of household debt relative to income also mean that each rate hike will bite much harder on Canadians’ spending power than in the past.
Add it all up, and we don’t see overnight rates going any higher than 2.5 per cent through 2011. That’s still a far cry from where we are now, and the bond market will sell off anticipating something worse as the first hikes hit.
But for equity markets, a soft climb in rates shouldn’t prove too problematic. History shows that in the vast majority of cases, the first six months after the Bank of Canada starts raising rates equity markets show decent returns on stocks, helped by the associated climb in earnings during that stage of the cycle.
By Avery Shenfeld, managing director and chief economist, CIBC World Markets Inc.
May 10, 2010
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