While it’s clear that interest rates are heading upward, CIBC World Markets says the hikes will fall below what many, including the U.S. Federal Reserve, are predicting.
“The nature of the upcoming expansion will dictate that, even at full employment, U.S. rates will have to be lower than in past cycles,” says CIBC Chief Economist Avery Shenfeld. “Similarly, Canadian overnight rates could end up reaching a plateau at surprisingly low levels.”
In both countries, the neutral rate—the level at which an interest rate neither stimulates nor restrains economic growth—could be only 2.5%, well below the 4% the Fed forecast at its latest meeting.
Shenfeld says both Canada and the U.S. are headed for substantially slower growth in the working-age population, decelerating to less than half the pace seen in the last expansion. Unless productivity soars, he says the pace of potential (non-inflationary) real GDP growth will also decelerate. In addition, lacklustre capital spending and increased savings rates—particularly in emerging market economies—puts a further damper on the prospects for economic gains.
Former U.S. Treasury Secretary Larry Summers sees these factors driving industrialized countries, including the U.S. and Canada, towards “secular stagnation”. He is calling for the use of ramped up debt-financed infrastructure spending as an alternative to another housing bubble to get the U.S. economy back on track. But for Shenfeld, maintaining a lower path for interest rates, and for Canada, keeping its more competitive exchange rate, will also be key.
“If we don’t turn to larger fiscal deficits, monetary policy will have to provide enough of an offset to those drags on growth. Ensuring that the interest rate differential with the U.S. stays narrow enough to keep the Canadian dollar at a level competitive for exporters will allow the economy to tolerate the end of the housing boom,” he adds.
He notes that in Canada, the exchange rate has enough influence to complicate estimating the neutral overnight rate, given the importance of overall monetary conditions in a small open economy. “Nevertheless, slowing potential GDP, along with high household debt levels that will increase the sensitivity of spending to rate hikes, both suggest that a nominal rate below 3% might be the longer-term neutral rate today.”
Read: Adapt to rising rates
While this is good news for the bond market, the co-authors are not making a bullish call just yet, since even if overnight rates in both the U.S. and Canada pause at 2.5% for an extended period of time, the bond market in 2014-15 might not anticipate a long pause and overshoot in their sell-off.
“To bond players, rate hikes are like potato chips; once you eat the first one, you go through the whole bag,” says Shenfeld.
He expects bond rates to climb sharply next year, but reverse course in 2016 as central banks take an early breather on rate hikes. He expects 10-year U.S. Treasury yields to top out in the 3.5% to 4% range in this cycle, about 100-150 basis points below the last decade’s peak. In Canada, he says yields should be lower given the country’s higher credit rating and lower government debt.
“While expecting higher yields through 2015, we see the Bank of Canada surprising markets with a pause on rates in 2016 and the Fed doing so after one more hike, helping bond yields recoup some lost ground,” he says.
As well, he believes a more gentle climb in rates “will be a plus for equity multiples”.