As the pace of inflation continues to blister, central banks on both sides of the border have been steadily increasing interest rates. Both the Bank of Canada and its American counterpart, the US Federal Reserve, have steadfastly hiked their trend-setting rates -- the Overnight Lending Rate in Canada and the Federal Funds Rate in the US -- since March, which has had a sharp impact on the variable cost of borrowing. Respective bond markets in both countries have also been highly reactive, with yields reaching new highs for five-year government debt, pushing fixed rates ever higher as well.
As a result, borrowers in both countries are desperate for some rate relief, and recent signs show Canadians may be the first to get it. While enforcing that “more needs to be done” on inflation, the Bank of Canada has been signaling it’s nearing the end of its hiking cycle. It implemented a smaller-than-expected hike of 50 basis points (bps) in its last announcement on October 26, raising optimism among analysts that a “pivot” is underway.
In contrast, the latest messaging from the Fed has been very hawkish. A persistently high inflation rate of 8.5% prompted a jumbo 75-bps hike -- its fourth consecutive -- last Wednesday to 4%, the highest level for the FFR since 2008. The accompanying statement reads, “Ongoing increases in the target range will be appropriate," perhaps alleviating any doubt that the Fed could be slowing its roll in the foreseeable future.
This could all pose a snag for Canada’s intended soft landing; the two central banks have a long history of moving in tandem on monetary policy. Given our dependence on the juggernaut of the US economy, there isn’t much leeway for our central bank to strike out alone. Could the Fed’s commitment to a more long term -- and aggressive -- approach, stall the end of the Bank of Canada’s hiking cycle?
Doug Porter, Chief Economist and Managing Director, BMO Financial Group, tells STOREYS that there’s no hard and fast rule that the BoC must emulate the Fed’s monetary policy -- and that there have been times in the past when it’s taken an independent stance. What’s more typical, he says, is that what ails our American neighbours will have similar consequences for Canucks.
“There’s nothing carved in stone that says that the Bank has to follow the Fed, but there are two things to always keep in mind,” he says. “One is that, usually, the forces that are driving the Fed to move on interest rates will be affecting the Canadian economy in a broadly similar manner -- if they’re facing severe inflation pressures, we’re probably facing something pretty severe as well. If they’re facing severe downside growth, we probably are as well. The broader macro drivers tend to have the same impact on both central banks and they’ll be largely guided by that. So it’s no surprise that in most years, in most episodes, the Bank is usually pretty close to the Fed.”
Despite this, however, it can’t be denied that there is some divergence between the two central banks right now; the BoC is walking a narrow path with housing market shocks on one side, and currency devaluation on the other.
“At this point, I think the Bank of Canada is signalling to Canadians that it’s not going to be able to completely keep up with the Fed. That doesn’t mean that there won’t be rate hikes; the decision for December is probably between 25 to 50 basis points, but that’s different than the deliberations at the Eccles Building in Washington,” says Royce Mendes, CFA, Managing Director & Head of Macro Strategy at Desjardins Capital Markets.
A key difference between the two economies, he points out, is the weight of the housing market on overall GDP -- between 8 - 10% in Canada compared to just 5% in the US -- plus heftier debt loads being carried by Canadians; the national debt-to-income ratio here is 180%, double that of our American counterparts.
“That matters because the way interest rates really work their way through any developed economy is primarily through the housing market,” Mendes says. “And the Canadian housing market has been ice cold lately. That is going to create, and has already created, a significant drag on the overall economy because it’s a bigger share here in Canada than it is in the US.”
The Bank of Canada will also be loathe to squeeze mortgage borrowers any more than they have to, Mendes adds; the steep upward trajectory of both fixed and variable mortgage rates have led to some anomaly trends in today’s marketplace. For instance, first-time homeowners -- who would have locked into their fixed-rate mortgage back in 2017 -- are now renewing at rates up to 20% higher than their original contract.
“What does their mortgage payment look like now? Well, over past decades, most of the time, people who took out their fixed-rate mortgage were always doing so at a lower rate,” he says. “Their payments were falling, they had paid down principal, and they were enjoying falling interest rates, but this is very different today.”
On the variable side, anyone who took out a new rate between May 2020 and July 2022 are now on the receiving end of lender phone calls, informing them their mortgage is hitting their trigger rate (when their payments no longer go toward principal), or their trigger point, when higher interest servicing means they now owe more on their mortgage than they did originally. This is a trend Mendes considered a “non-linearity” in terms of rate hikes.
In contrast, American borrowers have largely been shielded by trigger rates as their mortgage terms are structured on a 15- to 30-year basis.
“They have the option to refinance their mortgage, but in a rising rate environment, if you look at the refinancing statistics, they’re basically zero. Nobody is deciding to refinance their mortgage,” Mendes adds. “So these are reasons why I think there could be some divergence between the central banks.”
However, should the BoC's rate linger too far below the FFR, they risk softening the CAD, which in part would feed inflation growth -- the very phenomenon they're trying to stem with rate hikes.
“You can only go so far, because of the currency impact,” says Mendes. “So if the Federal Reserve decided it needed to hike rates well above 5% and the Bank of Canada was holding true to its word that we’re much closer to the end of this rate hiking cycle, we'll end up at 4%. That’s not priced into the market, that’s not priced into the value of the Canadian dollar, and that would create a situation where interest rate differentials would widen and capital would flow out of Canada into the US because of the higher interest rates, and that would cause a depreciation of the Canadian dollar.”
That in turn would stoke inflation, given the US is Canada’s largest trading partner, translating to higher prices for imported goods, and -- most acutely -- food prices.
“[The currency] is the primary channel through which a significant deviation between the Bank of Canada and the Federal Reserve could play out in financial markets, where it could have some unwanted side effects,” says Porter, who adds that up until this point, just 25 basis points have divided the two banks’s rates, and that the BoC has lead the way with hikes.
“For all intents and purposes the Bank has largely been matching the Fed step by step -- but it’s been the Bank actually making the decision first, that’s an interesting sidebar,” he says. “The Bank has, purposely, over the years scheduled its meetings to fall a week or two before the Fed, so it’s tough to accuse the Bank of Canada of mimicking what the Fed does, when they’re actually deciding first.”