Canadian interest rates – probably level from here

The Bank of Canada “surprised” the market by increasing rates by a quarter point.

What I am feeling very regretful about is about a month ago I thought they were going to do it, but the BAX futures were assigning a rough 20%-25% probability of them doing it. I should have dipped my toes in there.

Readers of history (and it really feels like history since it happened such a long time ago) will recall that the last time they raised interest rates (from 0.25% to 1.00%) they did it in three consecutive meetings with three 0.25% rate increases.

The Bank of Canada clearly had a target in mind and contrary to what the talking heads on the media have to say about the matter, I think they will hold at 1% for the intermediate term. There are a couple reasons for this, but one is that their original policy stance to stay at 1% (before they dropped to half a point) is that the Bank of Canada has accumulated considerable research that ultra-low policy rates create their own risks by virtue of being so low. There seems to be “mean reversion” to this. The other is that the inflationary threat does not appear to be forthcoming at present, especially now that the Canadian export economy will be dampened by the increased Canadian dollar.

There is also the matter of bringing the short term rates up to a point where the spread between the short-term and 10-year bond will converge to nothing. The federal reserve is going to run into the same problem when their central bankers will be asking themselves a correlation/causation question of whether an inverted yield curve is a predictor of a recession, or whether an inverted yield curve causes one.

Markets are predicting a 70-75% chance that the Bank of Canada will raise rates by the end of the year. If this goes to 80% or higher I’ll probably take a bet against rate increases.

This brings me to my next point, which is the Canadian dollar. It has risen dramatically over the past three months.

In fact, the rise in the Canadian dollar has been my biggest portfolio “miss” over this time – it has generated a lot of paper bleeding since I keep my portfolio balanced between CAD/USD. The Canadian dollar has gone up 6.5% from July 1st of this year, and it has represented a 3.2% drag on performance quarter-to-date. My gut instinct says to increase my own position of USD but I am still reluctant to do so since the momentum of the Canadian dollar feels like it is stepping in front of a freight train. There is probably a logical point to do so (around 85 cents if it gets there?) but it is something I am acutely looking at.

An increase in my USD positioning will mean that my research will be more US dollar-focused. I have been focused on Canadian securities for a considerable period of time, but considering what bland opportunities I have found in domestic markets, it is probably a better for me to set my sights south for investment candidates.

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