Economic analysis

Stephen Poloz’s job is about to get harder

How an interest rate gap could bite consumers, housing and the loonie
Bank of Canada Governor Stephen Poloz listens to remarks after addressing the Canadian Club of Toronto on Thursday December 14, 2017. THE CANADIAN PRESS/Chris Young

U.S. President Donald Trump is creating headaches for a lot of foreign officials these days, Stephen Poloz included. The Bank of Canada governor could find his job even trickier in the next year, as the U.S. increases interest rates at a faster clip. The question for Poloz is whether to follow suit, and risk reining growth in too much, or hang back, which could result in downward pressure on the loonie. Either way, it could be challenging.

Both countries’ economies are growing but under Trump, the U.S. slashed corporate taxes and passed a US$1.3-trillion spending bill, which will juice the economy and make higher interest rates a given. The U.S. Federal Reserve already hiked once last week, and Canada has stood still.

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Canada doesn’t have the same fires stoking its economy. GDP growth is slowing, oil prices haven’t recovered, and the housing market is no longer providing the lift it once did. Markets were anticipating two more rate hikes this year, but the odds are now skewing toward just one. “We happen to think the Bank of Canada may not manage to pull off quite as many as the Fed,” says Eric Lascelles, chief economist at RBC Global Asset Management.

When monetary policy diverges in the two countries (even slightly) Canada feels the effects. Start with bond yields. “The number one predictor of a Canadian 10-year bond yield is not the Bank of Canada,” says Lascelles, “it’s the U.S. 10-year bond yield.” U.S. government bonds serve as a benchmark against which other bonds are priced—especially the Canadian variety, given the close ties between the two economies. Sure enough, the yield on a Canadian 10-year bond has risen in tandem with its U.S. counterpart since the start of the year, even as Poloz has signaled caution ahead. (Bond yields move inversely with bond prices, and rising yields tend to signal expectations of higher growth and inflation ahead and, therefore, higher interest rates.)

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Rising bond yields put direct pressure on mortgages and other loans. And given Canada’s record-high debt burden, that’s no trivial matter. Household debt stands at 170.4 per cent of income. Last year, the Bank of Canada estimated that 31 per cent of residential mortgages with the Big Six bank lenders are up for renewal in the next one to three years. Those borrowers will likely face higher monthly payments upon renewal. According to Ben Rabidoux, president of North Cove Advisors, that hasn’t happened on a sustained basis since the 1990s. Up until now, monthly payments have been falling.

So how much more can borrowers expect to pay? In 2013, the average rate on a five-year fixed mortgage was 2.99 per cent. If the Bank of Canada hikes two more times this year, some households could be renewing at a rate 75 basis points higher than what they previously paid, according to Rob McLister, CEO of intelliMortgage Inc. in Toronto. On a $300,000 mortgage with a 25-year amortization, that works out to an additional $97 per month. McLister says that most households should be able to refinance to lower their payments, however. “Remember, the majority of folks who’ve paid a mortgage for five years have whittled down their balance and amassed equity,” he says.

Still, it’s a point of concern for the Bank of Canada, especially after raising its benchmark rate three times since May 2017. The country’s banking regulator also implemented a more rigorous mortgage stress test that went into effect in January, slowing real estate activity. The central bank is closely monitoring how consumers and the broader economy are reacting to these substantial changes. If there’s additional pressure on rates as a result of the U.S. Fed, that’s just one more reason Poloz may want to hold fire.

But just how much can the actions of the Fed influence rates in Canada? Beata Caranci, chief economist at TD Bank, doubts another rate hike in the U.S. would have much of an impact on bond yields in Canada. “We’re talking about 10 basis points, so a relatively small change,” she says.

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Beyond rates, the Canadian dollar is affected, as well. Rate hikes in the U.S. cause the greenback to appreciate against the loonie, which currently stands at around US77 cents. More tightening down south would exacerbate that trend, unless Canada keeps pace on rate hikes, which is unlikely. That may actually work in Canada’s favour, for now. The country’s export sector has been underperforming, a longstanding concern of Poloz. “The export side has not been as strong as one would think, especially with a U.S. economy doing well,” Caranci says.

While the uncertainty around NAFTA negotiations is likely keeping trade subdued, a lower dollar makes Canadian goods cheaper, potentially leading to greater exports and stoking a recovery in that part of the economy. There is a further complication, though. A lower dollar also boosts inflation, as imported goods become more expensive. The latest inflation data from Statistics Canada last week already came in slightly stronger than expected.

Still, these are the classic monetary policy issues that Poloz should be comfortable grappling with.  What may end up to be far more difficult is trying to deal with the many unknowns around trade, tariffs and protectionism, all stemming from the whims of a capricious U.S. President. That’s something no central bank model can predict.