Category: Canada

It is ironic that one victim of higher interest rates is the Bank of Canada itself.

After engaging in a massive amount of quantitative easing, as of October 26, the Bank still has about $400 billion of government bonds on their books. They collect interest income from these bonds as payments are made (a journal entry from the Government of Canada to the Bank of Canada). You can view the holdings and come to a calculation of approximately $5.9 billion a year in interest income that the Bank will earn from their “investments”. The Bank stopped publishing exact details of their $11.8 billion provincial debt holdings in 2021, but if we just model it at 25bps higher than the federal government, we get another $200 million in interest income, for a total of $6.1 billion a year.

This modelling is not quite correct – the above calculations used strictly the coupon rate for the government debt securities, and not the more appropriate measure of using the market yield to maturity as the basis for the revenues earned for government debt. Using this metric, the calculation bears less revenues – the 2nd quarter report of the Bank of Canada indicated $1.163 billion in interest revenues, which equates to about $4.65 billion annually. The $6.1 billion estimate above is too generous.

Pay attention to a typical interest rate announcement. The first paragraph is the following:

The Bank of Canada today increased its target for the overnight rate to 3¾%, with the Bank Rate at 4% and the deposit rate at 3¾%. The Bank is also continuing its policy of quantitative tightening.

If you are a member bank and wanted to borrow money from the Bank of Canada for a day, you would pay the Bank Rate. Conversely, the Deposit Rate is the money the Bank of Canada gives you for parking your money in reserves.

However, in our world of quantitative easing, a significant portion of the government debt purchased by the Bank of Canada got converted into two primary liabilities – the Government of Canada account, and the reserves of member banks (“Members of Payments Canada”).

When QE was going on, these liabilities resulted in insignificant payments – the deposit rate was 0.25%. However, interest rate increases have significantly increased the deposit rate to the 3.75% we see today.

As of October 26, 2022, the Bank of Canada held $282 billion in reserves held by banks and the Government of Canada. With the deposit rate now at 3.75%, the Bank of Canada now has to pay off $10.6 billion and this only offset by roughly the $4.6 billion a year received from the Bank of Canada’s bond portfolio on an annualized basis (and subtracting amounts that get quantitative tightened over time). The Bank of Canada also has an operating budget (to pay for staff, office space, IT, etc.) which annualized, is around $720 million.

My quick paper napkin calculation suggests that at a 375bps rate, the Bank of Canada will be losing around $1.6 billion quarterly as long as they have the roughly $282 billion in deposits on their books (currently $96 billion held in the Government of Canada’s name, and $186 billion held in member bank reserves). If the Bank of Canada stops paying the Government of Canada, this number goes to about a $3 billion a year loss. This number gets reduced in 2023 if the Bank of Canada continues its QT program, but such stemming of losses would be potentially offset by further interest rate increases. The number only swings back to profit when the Bank has eliminated the reserves on its liability book, or if it chooses to decrease the deposit rate.

Section 27 of the Bank of Canada Act is the mechanism where the Bank will remit proceeds over a certain amount to the Government of Canada – essentially sending its profits to the government. The legislation does not work in the other direction – it is implied that the Bank of Canada will always be making money! Some minutiae of the Bank of Canada states the following:

At 31 December 1955, the statutory reserve had reached the maximum permitted under the Bank of Canada Act of five times the paid-up capital. Since then, all of the net revenue has been remitted to the Receiver General for Canada. Following an amendment to section 27.1 of the Bank of Canada Act, the special reserve was created in 2007 to offset potential unrealized valuation losses due to changes in the fair value of the Bank’s investment portfolio. An initial amount of $100 million was established at that time, and the reserve is subject to a ceiling of $400 million. Effective 1 January 2010, based on an agreement with the Minister of Finance, the Bank will deduct from its remittances an amount equal to unrealized losses on available-for-sale assets. Prior to 25 March 2020, this category includes Other deposits.

The government has generously allowed the Bank of Canada to deduct its losses from the 2008-2009 economic crisis, which was not really needed because the Bank did not engage in wholesale QE during that era (less than $40 billion of reverse repurchases, which is a drop in the bucket compared to the numbers we see today – and they were settled in 2010).

However, this time is different, and the Bank of Canada will be facing significant losses as long as interest rates continue to remain at elevated levels. Their Q3 report will show a loss, and their Q4 report will show a big loss. It will blow through the $400 million reserve in short order.

I can imagine the upcoming hilarity that is going to occur on November 3, when the government announces the fiscal update which will likely include more “anti-inflationary (deficit) spending”. Part of this hilarity involves the government having to draft legislation to permit the Bank of Canada to incur losses and beg for money to keep operating. Just imagine the political backlash when Canadians learn that the Bank of Canada will be one more fiscal lead anchor that the public has to subsidize and also the sight of Tiff Macklem going to Finance and begging for money from the government to maintain the payroll.

Back on October 7, I wrote the following:

Until things blow up, my nominal trajectory for Canadian short-term interest rates will be:

October 26, 2022 – +0.50% to 3.75% (prime = 5.95%)
December 7, 2022 – +0.25% to 4.00% (prime = 6.2%)
January 25, 2023 – +0.25% to 4.25% (prime = 6.45%)
March 8, 2023 – +0.25% to 4.50% (prime = 6.7% – think about these variable rate mortgage holders!)

Note that the Bankers’ Acceptance futures diverge from this forecast – they expect rate hikes to stop in December.

We might see the Canadian 10-year yield get up to 375bps or so before this all ends, coupled with the Canadian dollar heading to the upper 60’s.

This October 26 prediction was a non-consensus call, with the markets generally pricing in a 75bps increase and me sticking my neck out with 50bps. I nailed it.

The 10-year government bond yield did eclipse 3.75% on October 21, but I am not claiming victory here – the intention of my post is that it will be occurring later in the future when it dawns into the market that short term rates are not dropping.

The Canadian dollar clearly hasn’t gone into the 60’s yet, but it should happen.

I get the general sense that the market is pricing in a change in the second derivative of the interest rate trajectory. The pattern looks very elegant – 25bps, 50bps, 50bps, 100bps, 75bps and now 50bps, and they expect another 25bps in December and then it’s done. Since the light can be seen at the end of the tunnel, party on, start playing the low interest rate trade since surely the Bank of Canada and Federal Reserve is going to loosen policy again and send everything skyrocketing.

It will not be this simple. Long term bond yields will rise and markets will fall when they come to the realization that inflation has not subsided.

Recall that inflation is not increased prices, but rather the expansion of money supply against a fixed amount of goods and services. Increased prices are a consequence of inflation.

The reason is that this assumption that market participants believe that central banks will come to the rescue in the event the economy tanks is what is causing the rates to continue increasing. It will only be when people are begging and pleading for relief that the central banks will relent, and likely bail out the entire populace with the introduction of a centrally administered digital currency.

The key metric to watch out for is employment. Although full employment is the mandate of the US Federal Reserve, it is something that the Bank of Canada will be paying attention to, albeit a lagging indicator.

We need to see unemployment rates climb before the psychology of inflation gets stabbed in the chest.

Until then, every item purchased at Costco and Walmart, every restaurant meal, every hotel and airline ticket, represents an element of aggregate demand which the supply is clearly still not expanding to.

There are signs that the tightening monetary environment is having an effect. Monetary aggregates have barely budged over the past year (M2++ is up 1.4% from January 1 to August 1 this year when the typical trendline is around 5%). But we are in a waiting period where corporations and individuals need to burn off their reserves before engaging in the real difficulty of belt-tightening that comes after some very poor fiscal and monetary decision-making.

Using a physical analogy, we have been eating daily at a buffet for the past two weeks and the 10 pounds of excess weight that we have gleefully put into our stomachs need to get worked off. Although the food has been taken away relatively quickly (rising interest rates), the fat on the waist is still showing (we still have a huge surplus of liquidity from the 2020-2021 fiscal/monetary actions).

Until we see signs of unemployment and, in general, “pain”, interest rates will slowly climb until we see people lose jobs. The Bank of Canada governor is slowing things down for political reasons more than anything else – he doesn’t want to be seen as the guy crashing the economy – and you can be sure that politicians of every political stripe, whether red, blue, orange, light blue or green, will be sharpening their knives and polishing their talking points.

Tiff Macklem gave a speech today in Halifax, trying to rationalize getting blindsided by inflation. Key quote:

At the time, we assessed that the effect of these global forces on inflation was likely to be transitory. Historical experience has taught us that supply disturbances typically have a temporary effect on inflation, so we tend to look through them. A year ago we expected inflation in goods prices to moderate as public health restrictions were eased, production ramped up and investment in global supply chain logistics picked up. In hindsight, that turned out to be overly optimistic.

I’m surprised his speechwriters haven’t sanitized the word “transitory” out of his vocabulary yet.

The forward-looking payload of his speech is on the “Inflation Expectations” sub-heading. Essentially the Bank of Canada is on a mission to target inflation expectations, rather than inflation itself because the key risk is entrenchment of expectations:

That’s why we are so focused on measures of expected inflation. We use a range of surveys and market-based measures to assess expectations of future inflation, and they show us that near-term expectations have risen. Survey results also indicate that consumers and businesses are more uncertain about future inflation and more of them expect inflation to be higher for longer. So far, longer-term inflation expectations remain reasonably well anchored, but we are acutely aware that Canadians will need to see inflation clearly coming down to sustain this confidence.

They will keep raising rates until they’ve triggered this sentiment, which is likely to happen when the labour market has transformed into one where people are grateful for employment (read: no more upward wage pressure) and the economy goes into the tank.

Until things blow up, my nominal trajectory for Canadian short-term interest rates will be:

October 26, 2022 – +0.50% to 3.75% (prime = 5.95%)
December 7, 2022 – +0.25% to 4.00% (prime = 6.2%)
January 25, 2023 – +0.25% to 4.25% (prime = 6.45%)
March 8, 2023 – +0.25% to 4.50% (prime = 6.7% – think about these variable rate mortgage holders!)

Note that the Bankers’ Acceptance futures diverge from this forecast – they expect rate hikes to stop in December.

We might see the Canadian 10-year yield get up to 375bps or so before this all ends, coupled with the Canadian dollar heading to the upper 60’s.

Recall that interest rates only started to rise on March 2, 2022. It typically takes a year for these decisions to permeate into the economy (capital expenditures cannot start and stop on a dime unlike interest rate futures).

By the end of the first quarter of 2023, things will have gone sufficiently south that people will be begging and pleading for a stop to the torture. There will obviously be a decline in discretionary demand by this point. The question is whether this will actually impact inflation expectations. I’m not so sure – expectations is also a function of public confidence and the question is whether we have seen anything to actually restore confidence – I don’t see anything on the horizon in this respect.

The litmus test is the following – say somebody handed you a stack of $10 million dollars and gave it to you a 10-year rate fixed at the current prime rate (5.45%) (which is a luxury only investment grade corporations would get at the moment). What would you do with it?

Probably most of you reading this would say “invest it in XYZ”, but say I put a future condition on the loan, which would be that you actually had to invest it in a physical capital project involving machinery and equipment and the like (and not through the construction of yet another self-storage facility either!). What would you put your money into?