Interest Rates Are on the Rise. Here’s Why.

January 19, 2018 Wesley Blight

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As expected, the Bank of Canada (BoC) raised its overnight interest rate on Wednesday, January 17, from 1% to 1.25%. In the official announcement and the monetary policy report released on the same day, the Bank cited more robust economic growth here in Canada and abroad as important factors in the decision.

The economy is living up to its potential

From 2008 until mid- last year, Canadian economic growth had been sluggish according to the BoC. Inflation, along with price pressure, stays low in that kind of environment. But economic expansion has begun to accelerate, and is at, or very near, its potential capacity for the first time since before the financial crisis.

Because economic growth that exceeds capacity is inflationary by nature, the BoC has raised interest rates to slow expansion and keep inflation near its 2% target, and more hikes could follow. The potential output for the Canadian economy is lower today than it has been in the past, however. That means the BoC—even when they raise rates—will not raise them to historic highs.

Broadly sourced economic growth and the employment outlook

Consumer spending is being supported by improved growth in business investment, exports, and government infrastructure spending as the primary drivers of economic growth in Canada. Canadians won’t be able to maintain past levels of spending as debt costs rise—less reliance on consumer spending provides more robust economic growth.

Job creation also continues to increase, unemployment has fallen to historic lows, and wage inflation has increased (albeit modestly), providing additional support for Wednesday’s rate increase.

But future hikes aren’t guaranteed…

Still, there are several potential reasons the BoC might limit future hikes. For example, though labour market data has been robust, modest wage inflation might not be sufficient to service elevated debt for Canadian consumers.

Moreover, the capacity for economic growth might be larger than expected, in which case inflationary pressure would be muted. And the uncertainty around NAFTA renegotiations continues to cast a pall on our ability to predict future economic growth.

Nevertheless, we anticipate interest rates to continue down the path of modest increases in 2018.

What this means for you

Short-term Canadian bond yields have moved up significantly since June of last year as investors around the world have positioned their exposure for higher interest rates from the world’s central banks. After Wednesday’s announcement, the Canadian dollar dipped initially then rallied against the U.S. dollar. By contrast, Canadian treasury yields were little changed.

Our fixed income fulfillment remains positioned for modest increases to Canadian interest rates.

With slightly less than benchmark duration, an overweight exposure to Canadian corporate bonds, and a purposeful allocation to diversified foreign and non-investment grade holdings, our fixed income funds and pools are invested in an appropriate manner for capital preservation.

Volatility within fixed income markets has been low for the last few years; however, as investors adjust to the prospect of higher rates in 2018, we expect volatility to increase. Partially as a result, our fixed income funds and pools are more defensively positioned with lower than maximum exposure to foreign and non-investment grade investments, higher credit quality, and reduced interest rate risk.


No Surprise, the Bank of Canada Raises Rates

The Bank of Canada raised its policy interest rate to 1.25% today, in a widely expected move.

The Canadian dollar dipped initially then appreciated against the U.S. dollar in response. Canadian treasury yields were little changed.

The rate of economic expansion in Canada and abroad—among other factors—contributed to the Bank of Canada’s decision to raise rates. Future hikes are likely for the same reasons but are not certain. Relatively low wage inflation, a potentially larger than expected capacity for economic growth, and the uncertainty around ongoing NAFTA renegotiations are all factors that may limit future hikes. With that being said, our expectation is for the policy interest rate to increase another 0.25% to 0.50% in 2018.

We’ll post an update on Friday with a more detailed analysis of the announcement and what it means for your portfolio.

 

About the Author

Wesley Blight

Wesley Blight, CFA, CIM, FCSI, is an Assistant Vice President with the Investment Management and Strategy team at MD Financial Management. He is responsible for the investment results of the firm’s fixed income and multi-asset products.

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