Canada may cut interest rate below that of U. S.
The Bank of Canada is fighting the Fed for just the second time in two decades, joining global peers that are cutting interest rates as the U. S. is poised to tighten. Blame it on the oil crash.
The Federal Reserve will raise its key rate as early as June, while borrowing costs in Canada are headed lower even after the surprise cut in January, economists predict. The trend, spurred by the oil- price plunge and stronger U. S. growth, will bring the Fed’s benchmark rate above Canada’s for the first time since 2007.
That would mark a rare divergence between the two key rates given how closely Canada’s economy is linked to the U. S. The border nations are the world’s largest two- way trading partners, with the U. S. accounting for 75 per cent of Canada’s exports. No other Group of Seven nation’s monetary policy is more closely aligned to the Fed. The only other time Canada cut after a Fed increase was in 1994.
“There will be times when they diverge,” governor Stephen Poloz told reporters in London last week, referring to Canadian and U. S. monetary policy. “Those are usually fairly temporary things.”
Economists surveyed by Bloomberg predict Poloz will cut borrowing costs to 0.5 per cent by the third quarter, and Federal Reserve Chair Janet Yellen will increase U. S. rates to 0.75 per cent by year end. Canadian rates, now 50 basis points higher than in the U. S., will be 75 basis points lower by mid- 2016, the economists predict.
The divergence has been good for holders of Canadian debt. Canadian sovereign bonds have outperformed the U. S. by the most in more than a decade, on pace for gains of 3.4 through the end of the first quarter compared with 1.6 per cent for U. S. Treasuries. That’s the starkest contrast since the second quarter of 2003, Bank of America Merrill Lynch data show.
Since the early 1990s, Canadian short- term rates have been higher more than two- thirds of the time, averaging about 13 basis points higher, with a median spread of 50 basis points. The recent oil price weakness along with record levels of household debt means the paradigm may have shifted.
“It’s oil that has changed everything so dramatically for Canada,” said Jimmy Jean, a strategist in the fixed- income group at Desjardins Capital Markets in Montreal.
The divergence is a testament to Canada’s gathering difficulties — bloated consumer debt, lacklustre business investment, stagnant exports, depressed oil prices and stubborn labour- market slack. Scott DiMaggio, an investor at Alliance-Bernstein LP in New York, says Poloz will probably need to cut once more.
“There are some built- up stresses in the system around how levered the consumer is, where house prices are,” DiMaggio, who manages $ 9 billion in Canadian fixed- income assets, said in an interview. That, combined with the oil- price shock and an overvalued currency means “there are some adjustments that have to happen in the Canadian economy.”
Canada’s reliance on crude oil to drive the economy has turned from a blessing to a curse, as prices below $ 50 a barrel lead companies to cancel investment and cut jobs. At the same time, the nation’s manufacturing industry, hobbled by years of stronger exchange rates, is struggling to lead the world’s 11th- largest economy.
For Poloz, the question is whether Canada needs another shortterm dose of stimulus, with the Fed about to begin tightening.