(Bloomberg) -- Bond traders are growing increasingly skeptical that the Bank of Canada’s policy tightening cycle will ultimately keep pace with the Federal Reserve’s.
The BOC forecasts its neutral rate -- the level at which monetary policy is neither restrictive nor stimulative for the economy -- at 3 percent, above the Fed’s long-term projection of 2.875 percent. But market participants aren’t buying it anymore, pushing terminal rate expectations for Canada well below those of the U.S., to the widest gap in 10 months.
Some firms, including Toronto Dominion Bank and CI Investments Inc., say the trend is only beginning. While the BOC and Fed are both raising rates, the U.S. has significantly more room to tighten given recent fiscal stimulus and a deregulatory environment that should help spur growth, at least in the short-term. Meanwhile, Canada is dealing with high household debt that central bank Governor Stephen Poloz expects to persist for years, leaving the economy more exposed to rate increases.
“Given the debt and credit overhang, the question is how much can the central bank hike rates without slowing down domestic demand,” Mark McCormick, North American head of foreign-exchange strategy at TD, said in an interview. “That, alongside some of the structural changes in both the economies, makes us a little bit cautious on where current market pricing is on the terminal rates.”
Expectations for the long-term BOC policy rate have slid 14 basis points to 2.29 percent since the central bank last tightened monetary policy in January, based on overnight index swap trading. In contrast, the market-implied outlook for the terminal fed funds rate has climbed 36 basis points in the span, to 2.65 percent.
And after staging a rebound of nearly 5 percent since mid-March, the Canadian dollar has given more than half of it back in recent weeks as central bank officials have appeared reluctant to match America’s rate path trajectory. The loonie was trading at C$1.2882 per U.S. dollar as of 11:19 a.m. Thursday in Toronto.
Poloz said May 1 that Canada’s current policy rate of 1.25 percent is well below the economy’s neutral rate, stoking a flurry of activity in 10-year note futures and bank acceptance futures. Still, he tempered the hawkish sentiment by reiterating his concerns that leveraged households leave the economy more vulnerable to higher rates than in the past.
McCormick said he expects the Bank of Canada to hike once more in 2018, in July, and twice next year. That compares with his forecast for two more rate increases from the Federal Reserve this year and three in 2019.
“There’s substantial room for disappointment on that front, in terms of how many hikes we get,” said Kamyar Hazaveh, who manages C$13.5 billion as head of rates at CI Investments. “The U.S. has a lot more room to do the rate hikes and bring the overnight rate higher. Differences in policy, fiscal policy, are very stimulative for the United States.”
Hazaveh said he expects Canadian government bonds to outperform Treasuries. In line with that view, he’s exposed to long-term bonds in Canada but is positioned in the front of the U.S. curve to earn carry. Hazaveh also expects the Bank of Canada to hike just once more this year.
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