Interest Rate Catalysts

We’ll likely see no further Bank of Canada rate hikes till spring, and probably no more US rate increases “before 2012…”

That summarizes Desjardins’ interest rate call from its latest Economic and Financial Outlook.

Yves_St-Maurice_Desjardins Yves St-Maurice, Desjardins’ Director and Deputy Chief Economist, elaborated on that view, and provided some excellent background on factors which shape the direction of Canadian interest rates.  If you’re a student of interest rate behaviour, this interview is worth a read.


CMT: Yves, Desjardins’ outlook report states:  “It would take a major slowdown by the economy, substantial job losses or major interest rate increases for the housing market to collapse.” What is an example of a “major interest rate” increase?

YSM: Mortgage credit outstanding totaled $997 billion in June 2010. According to Statistics Canada, the first quarter ratio of mortgage debt service to personal disposable income was 41% below the peak reached in the early ‘90s. Given current levels of disposable income and mortgages outstanding, an increase of about 2.75 percentage points in average mortgage interest rates would be needed to return to that level. But, to have a collapse of the housing market, a higher interest rate increase would be needed—probably around 5 percentage points.

CMT: There is some debate over which affect home prices more: the level of unemployment or the level of interest rates. Which of the two is more heavily correlated to housing prices?

YSM: The impact of fluctuating interest rates is probably more important. Interest rates affect all mortgage holders, while job losses affect only those who have lost their jobs. Since 1998, the correlation coefficient between the price of existing homes and the 5-year mortgage rate has been -0.64, while that between house prices and the unemployment rate has been -0.53.

CMT: Many believe we won’t see appreciable rate increases until economic growth returns.What level of sustained GDP growth is typically associated with rising interest rates?

YSM: Before the recession, the annual growth potential of the Canadian economy was slightly above 2.5%. The Bank of Canada has usually raised its interest rates when economic growth exceeds this level over a certain period of time. Since the early 90s, the annualized quarterly growth of Canadian real GDP was 3.5% on average during monetary tightenings.

CMT: Inflation is also an important factor so, other things being equal, what kind of sustained core inflation would the Bank of Canada have to see in order to consider raising interest rates?

YSM: Higher than 2% (which is the Bank of Canada’s target) for several months.

CMT: Desjardins expects a 1% increase in Canada’s overnight rate in 2011, and no increase in the U.S. Fed Funds rate. That implies a 1.75% spread in the two country’s policy rates by year-end.  Would the Bank of Canada really allow that kind of spread, given its certain effects on our currency?  Or do they care? What is the most this spread has been in recent times?

YSM: Because the economic situation is quite different in Canada and in the US, a big spread between the key rates is justified. The spread will support the loonie but won’t necessarily cause it to appreciate strongly since commodity price gains will be limited. The spread between Canadian and US key rates reached 2.25% in mid-2006.

CMT: How much is risk-aversion affecting bond yields in Canada?  For example, given Desjardins’ interest rate model, is the “extraordinary demand” for bonds keeping Canadian 5-year yields significantly lower than they should be?  Is it possible to quantify roughly how much the current five-year government yield is undervalued?

YSM: The current elevated risk aversion strongly influences the Canadian bond market amid high demand for safe assets. A very rough estimate would be that without the current extraordinary demand for bonds, even if low economic growth would still warrant lower-than-average bond yields, the Canadian 5-year yield would be about 0.50% higher.

CMT: Is there any chance the Canadian bond market is in a “bubble?”

YSM: If there is a bubble, it is not just affecting the Canadian bond market but the global bond market in general, and in particular the U.S. bond market. There are many signs that the bond market is currently overbought, causing its valuation to drop especially when compared with the stock market. However we don’t think that the Canadian bond market is already in a “bubble” situation, even if we are starting to see some hints.

CMT: In general, how did Desjardins arrive at its prediction of a 6.20% prime rate in 2014?

YSM: Our prime rate forecast is directly related to our overnight rate forecast of 4.20% in 2014. This 4.20% forecast reflects the fact that we expect the Bank of Canada to bring its key rate near the “neutral rate” in the medium term. The neutral rate is the appropriate rate when the output gap is close and inflation is at the (Bank of Canada’s) target.

CMT: What is the margin of error in this 2014 prime rate forecast?

YSM: The margin of error on a 4-year financial forecast is always quite high, at least plus or minus 1% in this case. Our forecast presupposes that the Canadian economy will be in the middle of the economic cycle in 2014. If we are back in recession or in a situation of overheating, the key rate could be quite different.

CMT: Thank you Yves.

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