Author: CIBC World Markets - Benjamin Tal
Article Date: August 2007
We believe the increase in interest rates will be relatively modest.
CIBC World Markets The Bank of Canada’s 0.25% interest rate increase on July 10th was widely expected, with the bond market already discounting a second 0.25% hike in September. The recent increase in long-term interest rates and thus fixed-term mortgage rates reflect this expectation. However, we believe the increase in interest rates will be relatively modest, with most of the damage to fixed-term rates already behind us.
There are two important factors that should limit interest rate hikes.
1) It’s far from clear that the slump in the U.S. housing market is over. If the housing market continues to slide and the U.S. economy surprises on the downside, then the Canadian economy will feel some of the pain.
2) This also means the Fed might cut interest rates by the end of the year, which will make it very difficult for the Bank of Canada to raise rates. Such a situation would boost the Canadian dollar significantly (to well over 95¢) and negatively impact our manufacturing sector.
Another factor to consider is that most of the inflation in Canada is coming from the west. By raising interest rates too much, the Bank is risking taking Ontario into a recession.
The bottom line is that the Bank will raise interest rates, but probably not much. This means that the main damage from this point will be in the Prime rate, and less in the five year rate.
While all these forces are cyclical in nature, a more structural story is starting to impact interest rates. The retirement of baby boomers is fast approaching and will probably start to impact the labour market as early as 2009. This means that without a significant (and quick) improvement in the country’s productivity, the speed limit of the economy will gradually get lower (i.e. inflation can start emerging even when the economy operates at only around 2.5% growth rate). So beyond the current cyclical story, it seems that the downward potential of interest rates is limited, and it would take higher rates to control even a modest increase in inflation.
