Canada – Page 37

Eating a little bit of crow on interest rates

I strongly thought the Bank of Canada was going to raise 0.5%, and the futures markets were not inconsistent with this belief, but instead, they raised 0.25%. Global factors (including Europe) is likely the reason why they went for the more conservative rate hike. They have also said that future rate hikes are not going to be as quick as the markets anticipated:

In this context, the Bank has decided to raise the target for the overnight rate to 1/2 per cent and to re-establish the normal functioning of the overnight market.

This decision still leaves considerable monetary stimulus in place, consistent with achieving the 2 per cent inflation target in light of the significant excess supply in Canada, the strength of domestic spending, and the uneven global recovery.

Given the considerable uncertainty surrounding the outlook, any further reduction of monetary stimulus would have to be weighed carefully against domestic and global economic developments.

Now that I have completely destroyed any credibility that I had on the issue of short term interest rates, I will give my new projection:

July 20 (raise 0.25% to 0.75%)
September 8 (raise 0.25% to 1.00%)
October 19 (raise 0.25% to 1.25%)
December 7 (raise 0.25% to 1.50%)

Between now and the end of the year, the prime rate will rise from 2.25% to 3.50%, and your average variable rate mortgage of prime minus 50bps will go from 1.75% to 3.00%.

There is no indication that these quarter point rises will stop in 2011; although the markets are now hinting the short term rate will level off around 2.75% (prime rate of 4.75%). This will clearly be conditional on how fast the economy recovers and the onset of inflation.

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.

Canada ends the fiscal year with $47 billion deficit

The 2009-2010 year-end fiscal monitor is finally released. I will make some year-to-year comparisons.

From April 1, 2008 to March 31, 2009 the government posted a $2.2 billion deficit. In 2009-2010, the government posted a $47.0 billion deficit.

Revenues were down about 5% year-to-year, mainly attributable to a decrease in personal income tax and corporate income tax collections. The corporate side would have been a lot worse if it wasn’t for a huge recovery in the later part of the 2010 fiscal year.

The one interesting item is that the proxy for general consumption in the country, the Goods and Services tax, had a decrease of 0.2% year-to-year in revenues, so this is virtually unchanged. Similar to corporate income taxes, there was a huge surge in collections in the last part of the fiscal year.

On the expense side, government expenses were up approximately 17%. The bulk of this is attributable to the “economic action plan”, i.e. the stimulus package. The stimulus package, as projected in the 2009 budget, was approximately $23 billion, so one can infer that if it weren’t for the stimulus, the deficit would have been around $24 billion – a fairly manageable number.

Most notable is the 35% increase in Employment Insurance premium payments – mainly a function of increased unemployment, but also factored into this were government legislative efforts to enhance EI benefits for those that paid into the EI program for a lengthy period of time (7 years or over) receiving an extended amount of benefits.

My quick guess for 2010-2011 is that we will continue to see significant growth in revenues from the three main sources – personal income tax, corporate tax and GST collections in the 2010-2011 fiscal year. On the spending side, we will continue to see spending as well, and probably see a posted deficit of around $35-40 billion. This cannot continue indefinitely, otherwise Canada might face its own entitlement crisis. Although relative to other countries we are in better shape, we should be returning our fiscal balance to a mild surplus position and save some capital for future rainy days – which is more than likely to occur for the duration of this decade and beyond as the baby boomer generation retires.

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.

Canadian Interest Rate Projections – May 2010

I figure it would be helpful to see what the Canadian interest rate futures are doing and to make some projections as to what the market is saying about future rate increases:

Month / Strike	Bid Price	Ask Price	Settl. Price	Net Change	Vol.
+ 10 MA	0.000	0.000	99.375	0.000	0
+ 10 JN	99.150	99.160	99.250	-0.100	14740
+ 10 JL	0.000	0.000	99.365	0.000	0
+ 10 SE	98.730	98.740	98.820	-0.080	22075
+ 10 DE	98.340	98.350	98.410	-0.060	29381
+ 11 MR	98.050	98.060	98.100	-0.050	8873
+ 11 JN	97.740	97.770	97.810	-0.060	2777
+ 11 SE	97.440	97.480	97.550	-0.080	2076
+ 11 DE	97.220	97.270	97.310	-0.070	216
+ 12 MR	96.910	97.150	97.060	-0.250	1
+ 12 JN	96.550	96.930	96.860	0.000	0

My projection for the Bank of Canada overnight interest rate level is the following:

June 1, 2010 (+0.50% to 0.75%)
July 20, 2010 (+0.25% to 1.00%)
September 8, 2010 (+0.25% to 1.25%)
October 19, 2010 (+0.25% to 1.50%)
December 7, 2010 (+0.25% to 1.75%)

What has changed since my last projection is that the initial rate increase in June 1, 2010 will be 0.50% instead of 0.75%. I still see subsequent rate increases of 0.25% at each scheduled announcement. You can probably thank the European debt situation for this change.

Although Canada’s economy is much less linked to Europe than it is to the USA, it is enough to factor into the economic calculation. In particular, the Euro has dropped significantly and this will lessen the competitiveness of Canadian exports into the Euro market.

That said, relative to the US dollar, the Canadian dollar has slipped a little, but this probably isn’t enough to take into consideration other than “wait and see”.

Long-term rate projections, which is more relevant for mortgage pricing, has had rates drop over the past two weeks. 5-year bond rates are 2.74%, while the 10-year is at 3.47%, which is roughly the rates seen in the past three quarters. If the market stabilizes at the existing level, I would not be shocked to see a 5-year fixed mortgage rate offered at 4.00% in the next couple weeks.