Expectations were confirmed when the Bank of Canada (BoC) increased their overnight lending rate to 1.75%, the third 0.25% increase for 2018. While the bank has reiterated that future interest rate decisions will be data dependent, less cautious language used by the BoC about future hikes reinforces our expectations that additional increases will be made within the next 12 months.
Why did the BoC raise rates? Solid economic data and the USMCA
The BoC provided several reasons that not only support the October 24th decision, but also future increases.
- Canada's economic growth was broadly aligned with expectations. The Canadian economy is expected to grow an average of 2.0% over the second half of 2018 and real GDP is projected to grow by 2.1% in 2018 and 2019 before slowing to 1.9% in 2020. Furthermore, expectations for future growth is largely unchanged with tighter financial conditions being offset by improved trade certainty following the USMCA. The U.S. economy also continues to be robust and is expanding faster than anticipated.
- Projections for improved business investment and exports are balancing the sources of growth in Canada. With the domestic economy already growing near capacity, expectations for future expansion are a key support for higher rates.
- Household spending is expected to continue growing at a healthy pace, underpinned by solid employment income growth. Unemployment is near 40-year lows and Canadians have adjusted their spending. Credit growth continues to moderate and housing activity has also stabilized. This provides increased confidence in the ability of Canadians to afford the added cost of higher interest rates.
Positioning for higher rates, but actively assessing factors that could moderate the pace of future increases
While the BoC believes that rates need to rise to a more neutral stance to achieve the inflation target of 2%, expectations could be more moderate for a variety of reasons.
- Headline inflation (2.2%) and core inflation (1.5%) in the 12-months through the end of September were lower than expected. This was largely due to the transitory impact of lower energy prices, however lower than anticipated inflation may slow the path of expected hikes.
- Despite robust labour market data, wage inflation remains lower than expectations given the overall domestic growth story.
- Uncertainty remains regarding the China-U.S. trade relationship.
- Long-term bond yield are still higher than short-term bond yields, but the sovereign bond yield curves in North America have flattened. Expectations for further rate hikes will be muted should yield curves continue to flatten or invert.
No action in bond yields, but the Canadian dollar jumps
Given that the rate increase was widely anticipated, bond yields were little changed after the announcement. Similarly, expectations for further hikes has already been taken into account in current bond prices.
The appreciation of the Canadian dollar against the U.S. dollar (and most major currencies) did come as a surprise given today's announcement was expected, but we did see it trade lower as the day progressed.
Positioning away from short-term bonds and focusing on capital preservation
Our portfolios have been positioned for a rising interest rate environment for some time, with reduced exposure to short-term bonds in favour of cash and longer term bonds. Our fixed income funds and pools remain focused on capital preservation, investing in holdings with less sensitivity to increasing domestic interest rates.
For more information about the BoC announcement and what higher rates mean for you and your portfolio, please contact your MD Advisor. He or she can provide further details.