With the U.S. fac­ing head­winds and with ris­ing rates and growth at home, Canada is the sweet spot for debt mar­kets

Investment Executive - - CONTENTS - BY AN­DREW AL­LEN­TUCK

With the U.S. fac­ing head­winds, and in­ter­est rates and eco­nomic growth ris­ing at home, Canada’s in the sweet spot for debt mar­kets.

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 Stats Can 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 l ower 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, fixed­in­come, with Tridelta In­vest­ment Coun­sel Inc. in Toronto.

The dam­age caused by mul­ti­ple hur­ri­canes will have short­term 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 10year 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.

For the first time since Oc­to­ber 2014, Cana­dian in­ter­est rates are ahead of U.S. trea­suries

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