Bank of Canada holds steady

The Bank of Canada holds the overnight target interest rate steady which resulted in a very mild decrease in the Canadian dollar as traders positioned themselves when reading the language in the statement.

Specifically:

Underlying pressures affecting prices remain subdued, reflecting the considerable slack in the Canadian economy. Core inflation is projected to edge gradually up to 2 per cent by the end of 2012, as excess supply in the economy is slowly absorbed. Inflation expectations remain well-anchored. Total CPI inflation is being boosted temporarily by the effects of provincial indirect taxes, but is expected to converge to the 2 per cent target by the end of 2012.

This is “fed speak” that is likely “We’re not going to do anything on our next meeting as we see how things unfold.”

BAX Futures have nudged slightly up in reaction to the statement:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 11 FE 0.000 0.000 98.590 0.000 0
+ 11 MR 98.620 98.625 98.575 0.050 23240
+ 11 AL 0.000 0.000 98.520 0.000 0
+ 11 JN 98.380 98.390 98.350 0.040 29808
+ 11 SE 98.150 98.160 98.140 0.020 14591
+ 11 DE 97.940 97.950 97.940 0.000 13813
+ 12 MR 97.770 97.780 97.780 -0.010 6012
+ 12 JN 97.630 97.640 97.640 -0.010 1493
+ 12 SE 97.250 97.580 97.520 -0.010 814
+ 12 DE 97.350 97.410 97.370 -0.010 36

I still maintain that long-term rates maintain much more relevancy – 10 year benchmark bond rates are at 3.25%, and it is likely that in order for the Bank of Canada to raise short term rates that the long-bond will need to go higher. It is my guess that the BOC has a silent objective to keep a 2-2.5% yield spread between short term and 10-year rates.

Bank of Canada 2011 Review

In 2011, the Bank of Canada will have eight announcement dates for the short term interest rate target:

January 18
March 1
April 12
May 31
July 19
September 7
October 25
December 6

Currently, the BAX Futures have the following quotations:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 11 JA 0.000 0.000 98.590 0.015 0
+ 11 FE 0.000 0.000 98.555 0.015 0
+ 11 MR 98.540 98.545 98.540 0.005 8486
+ 11 JN 98.340 98.350 98.340 0.010 14721
+ 11 SE 98.160 98.170 98.160 0.010 15777
+ 11 DE 98.000 98.010 98.000 0.000 14316
+ 12 MR 97.850 97.870 97.850 0.010 6577
+ 12 JN 97.730 97.750 97.730 0.010 2365
+ 12 SE 97.620 97.630 97.610 0.030 692
+ 12 DE 97.440 97.510 97.460 0.030 0

The markets are inferring there is a chance the Bank of Canada will raise rates by 0.25% during the March 1 meeting, and if not by then, then a good chance on April 12.  Three month corporate paper is currently yielding 1.18% (98.82 on BAX).  Clearly, the market is pricing in inflationary fears as opposed to factoring in economic or currency differentials, relative to the USA.  For people that have floating rate mortgages or margin loans, your cost for these loans is likely to increase slightly throughout 2011.

Short term Bank of Canada rate snapshot

BAX futures suggest that the overnight target rate will be held at 1% for the December 7, 2010 Bank of Canada meeting:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 10 NO 0.000 0.000 98.690 0.000 0
+ 10 DE 98.710 98.715 98.710 0.000 4741
+ 11 JA 0.000 0.000 98.675 0.000 0
+ 11 MR 98.600 98.610 98.600 0.000 12558
+ 11 JN 98.460 98.470 98.460 0.000 15591
+ 11 SE 98.280 98.300 98.290 0.000 13157
+ 11 DE 98.140 98.150 98.140 0.010 7394
+ 12 MR 98.020 98.040 98.030 0.000 3483
+ 12 JN 97.930 97.970 97.950 0.010 274
+ 12 SE 97.850 97.930 97.910 0.010 108
+ 12 DE 97.780 97.830 97.830 0.010 7

The rates do suggest that by mid-year we might see another 0.5% increase in rates throughout 2011, but this is financially speculative noise peeking through the woodwork. 3-month corporate paper is yielding 1.17% at present, so there is not much of a divergence between existing rates and implied December 2010 rates.

In terms of long-term rates, Canadian 10-year bonds have crept up to 2.98% at the end of November 10th trading. While this is not anything significant in terms of the range over the past 12 months, it is up about a quarter point over the past month. The big scare for real estate gurus out there was likely in the early second quarter (April) when 10-year bond rates went to 3.7%. Still, this is nothing close to the past decade’s average of 4.3%, and the peak rate of roughly 5.96% back in the year 2001.

I am struggling to make what is a rather boring interest rate post interesting, so I will leave it here.

Possibility of a rate increase before year’s end?

I notice that the Banker’s Acceptances have dropped (implying future rate increases) over the past week. Current quotations are as follows:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 10 OC 0.000 0.000 98.640 0.000 0
+ 10 NO 0.000 0.000 98.630 0.000 0
+ 10 DE 98.615 98.620 98.650 -0.030 12401
+ 11 MR 98.450 98.460 98.520 -0.060 21511
+ 11 JN 98.380 98.390 98.450 -0.070 6701
+ 11 SE 98.310 98.320 98.380 -0.060 2617
+ 11 DE 98.250 98.260 98.310 -0.050 1526
+ 12 MR 98.190 98.220 98.240 -0.040 99
+ 12 JN 98.090 98.130 98.150 -0.030 7

Look at the December contract – implied pricing of 1.39%. On September 8th, this was 1.14%.

Three-month corporate paper is currently trading at 1.14%, which implies that we could be seeing one more rate hike (of 0.25%) before year’s end. The next Bank of Canada scheduled rate announcements are October 19 and December 7.

Canadian Interest Rate Futures

At 9am (eastern time) on September 8th, the Bank of Canada will make an announcement regarding the overnight target interest rate, which is currently 0.75%. The 3-month Bankers’ Acceptance futures market currently has the following quotations:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 10 SE 98.895 98.900 98.890 0.000 16669
+ 10 OC 0.000 0.000 98.795 0.020 0
+ 10 NO 0.000 0.000 98.785 0.020 0
+ 10 DE 98.850 98.870 98.850 0.010 19389
+ 11 MR 98.760 98.770 98.750 0.010 12911
+ 11 JN 98.670 98.690 98.650 0.020 6078
+ 11 SE 98.550 98.570 98.530 0.020 3172
+ 11 DE 98.400 98.430 98.400 0.110 363
+ 12 MR 98.270 98.310 98.270 0.100 262

A September and December contract at around 98.85-98.9 is projecting that there is a higher than average chance of a 0.25% rate increase this upcoming meeting, and then no further rate increases for the rest of 2010.

The market is likely going to be correct with this – I anticipate a statement that will state that domestic growth in Canada is quite good, but there remains significant risks outside the country that might affect Canada’s domestic economy.  A 1% short term rate, historically, is still very stimulative.

3-month corporate paper is yielding 0.98% on September 7th and 3-month T-Bills are yielding 0.78%.

In the last decade, the previous low bank rates were 2.25% in early 2002 and in the middle of 2004.

The main impact of the sum of these interest rate increase decisions is that the yield curve will be slightly less steep – traditionally banks make money by borrowing short and lending long.  So when rates were at 0.25%, they could borrow money at that rate, and then lend it out (the ultimate risk-free loan would be to the Government of Canada, which has a 10-year bond yield currently of 2.95%).  You would then skim the difference (2.7%) as profit, which is nearly risk-free.

By increasing interest rates, spreads shrink somewhat.  Assuming the Bank of Canada does raise rates to 1%, the spread will shrink to 1.95% for 10-year money which is still profitable, but not quite as profitable as it was at lower rates.

People with sensitivity to short-term rates (e.g. variable rate mortgages, margin balances in margin accounts) will feel the impact of this increase most directly.

Canadian Interest Rate Projections – August 31

Looking at Banker’s Acceptance Futures, we have the following rates:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 10 SE 98.915 98.930 98.925 0.000 16053
+ 10 OC 0.000 0.000 98.830 0.000 0
+ 10 NO 0.000 0.000 98.820 0.000 0
+ 10 DE 98.890 98.900 98.900 0.000 27314
+ 11 MR 98.820 98.830 98.830 0.000 25451
+ 11 JN 98.740 98.750 98.750 -0.010 8618
+ 11 SE 98.600 98.620 98.610 0.010 1774
+ 11 DE 98.480 98.520 98.490 0.020 1197
+ 12 MR 98.360 98.440 98.370 0.060 386

It looks like that there will be a higher than 50/50 probability that the Bank of Canada will raise their overnight target rate by 0.25% in their September meeting, but after that, future rates in the 2011 calendar year are projected to go up by 0.25% to 0.5%.

The drop in increase expectations has likely contributed to depreciation of the Canadian currency – currently at 94 cents US to a Canadian dollar, while this was high as 98 cents earlier in August, and at parity back in April.  During the depths of the economic crisis, the Canadian dollar reached 78 cents multiple times throughout the October 2008 to March 2009 period.

Bank of Canada Interest Rate Projections

Since the last 0.25% rate increase on July 20, the bankers’ acceptance futures have been quite calm. We have the following quotations:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 10 AU 0.000 0.000 98.905 -0.005 0
+ 10 SE 98.825 98.835 98.825 0.000 1825
+ 10 OC 0.000 0.000 98.725 -0.005 0
+ 10 DE 98.700 98.710 98.700 0.010 6190
+ 11 MR 98.580 98.590 98.580 0.010 4636
+ 11 JN 98.460 98.470 98.460 0.010 2213
+ 11 SE 98.310 98.320 98.310 0.000 904
+ 11 DE 98.140 98.150 98.130 0.010 303
+ 12 MR 97.950 97.960 97.940 0.020 104
+ 12 JN 97.770 97.790 97.760 0.020 54

This still hints that the short term rate will rise 0.25% by the September 8 or October 20 meeting, and the short term rate will end the year at 1.00% with a possibility of 1.25%. For the year 2011, rates are expected to inch higher by about 0.5 to 0.75%.

It should also be noted that at present, 3-month corporate paper is yielding 0.89%. This was approximately 0.4% half a year ago.

Finally, since 5-year bond rates have dropped considerably over the same time period (which is counter-intuitive to the economics 101 texts that state that longer-term bond yields will rise with an increase in interest rates), 5-year fixed term mortgages should also drop – the best one I can see so far is 3.87%.

Bank of Canada Interest Rate Projections

On July 20, the Bank of Canada is very likely to increase the overnight target interest rate from 0.50% to 0.75%; this has already been baked into the marketplace. The Prime Rate is likely to correspondingly increase from 2.5% to 2.75%.

In terms of what lies ahead in the future, we look at the only financial product in Canada that one can use to predict such rate changes, the 3-month Bankers’ Acceptance Futures:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 10 JL 0.000 0.000 99.045 0.030 0
+ 10 AU 0.000 0.000 98.960 0.030 0
+ 10 SE 98.875 98.880 98.880 -0.005 10612
+ 10 DE 98.700 98.710 98.710 -0.010 20474
+ 11 MR 98.540 98.550 98.540 0.000 17714
+ 11 JN 98.350 98.360 98.360 0.000 10038
+ 11 SE 98.140 98.150 98.140 0.080 2281
+ 11 DE 97.890 98.110 97.890 0.080 209
+ 12 MR 97.580 97.700 97.680 0.000 341
+ 12 JN 97.370 97.490 97.430 0.090 0

What we see is a 3-month future rate of 1.12% in September; and by years’ end we have a 1.29% rate.

There are four more meetings left in 2010; July 20, September 8, October 19 and December 7.  Right now, the market is speculating that there will be 0.25% increases in two of these meetings, leading to a year-end target rate of 1.00%.  It is possible that after September 8, that the Bank of Canada will leave short term rates unchanged for the duration of the year.

In 2011, the market believes that the short term rate will increase by about 0.75% above this; to 1.75%, still a very low rate by historical standards.

Presumably after its July20 statement it will change the language which will sufficiently guide the marketplace to adjust its prices.

Of note is the impact on mortgage rates; only variable-rate mortgages will be going up as a result of these short-term rate increases.  The reason is because longer-term rates are set by the marketplace, and these have gone down over the past quarter.  A 5-year government bond yields 2.49% currently; this was as high as 3.2% back in April.

Bank of Canada Interest Rate projections

The June 3-month banker’s acceptance futures are trading at 0.89% at present.

This suggests that the short-term interest rates (the target overnight rate) will likely raise 0.5% to 0.75%. However, the banker’s acceptances generally are a quarter point over the prevailing target rate, which suggests the market is pricing an approximate 40% chance that the Bank of Canada will only raise 0.25%.

One month T-bills are at 0.23%, 3-month T-Bills are at 0.47%.

My justification for a 0.5% raise is simple – they want to make a statement.

I rarely have strong feelings about currency trading, but my guess is that the Canadian dollar will spike briefly on the announcement and then will go through a decline.

Most of the media thinks that the Bank of Canada rate increases will result in currency appreciation, but they will get the opposite results – low interest rates causes a lot of currency holding through carry trading. Since traders are on the margin side, a higher rate will result in currency outflows. It is likely the US dollar will be the one to rise relative to the Canadian dollar, so I’d get your cross-border shopping in sooner than later. You can also do “cross-border shopping” by buying US equities. The markets suggest that the US federal reserve will start raising rates around the beginning of 2011.

Canadian Interest Rate Predictions

The last three weeks of market volatility have had a profound effect in driving demand for risk-free, liquid government investments. The Bank of Canada has been a recipient of some of this inflow, as demonstrated by the 5-year benchmark government bond rate:

Speculators would have made a fairly good gain had they bought around 3.1% and sold today at around 2.6%. Of course, the best trades are done in retrospect, so this is just like saying that I could have picked the last 6 digits of the lottery and won a million dollars. Whether the yield will go lower or not remains to be seen.

What this does mean, however, is that 5-year fixed rate mortgages are likely to drop from their existing levels of around 4.54% (at ING Direct) or 4.39% (a typical mortgage broker) to something down 25 basis points or so. I would expect the 5-year rate to be around 4.25% for most retail customers. I generally ignore the posted bank rates since they are always inflated and when negotiating, they usually have a standard rate that is a good percent and a bit below those rates. Competition has whittled that process down to a formality of just asking, but I am sure there are some financially uninformed people that believe the posted rate is the only one they can get.

The Bank of Canada will be raising the target (short term) rate on June 1. This is inevitable, but the question is whether they will be raising 50 basis points or 75 basis points. Right now the 3-month banker’s acceptance futures (the only short term interest futures instrument actively trading in Canada) is implying a June rate of 0.81%.

My prediction is that the Bank of Canada, on June 1st, will raise the overnight target rate 0.5% to 0.75%.

Since this is mostly baked into the markets, the effect this will have on longer-term rates is nil. However, for those that are on variable rate mortgages, they will be paying 0.5% more since the prime rate will go up a corresponding amount. On a $300,000 mortgage, this would mean $1,500/year in payments or about $125/month additional.

My projection for the end of December will be 1.5%, down from 1.75% as projected a month earlier. My prediction is that rates will go up another 0.25% on July 20, 0.25% on September 8, no change on October 19 and up 0.25% on December 7.