The Fed effect could spell trouble for Canada’s economy

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Merrill Lynch economist Emanuella Enenajor predicts that the Canadian financial system will import Fed-driven higher interest rates from south of the border. For the domestic economy, the timing could hardly be worse – it threatens a construction and housing market boom that remains as one of the few drivers of Canadian growth.

Historically, Canadian government bond yields have closely tracked U.S. bond yields, even when economic forecasts for the two countries are markedly different. In 2015, however, domestic bond yields have been moving lower, in part because of Bank of Canada interest rate cuts, while U.S. Treasury yields have moved higher.

For investors, Ms. Enenajor highlights the risk that this trend reverses and Canadian yields are dragged higher by Fed policy when they are not justified by economic fundamentals.

In the United States, consistently strong employment data and economic growth expectations of 2.5 per cent for 2016 gave Fed chair Janet Yellen the confidence to begin removing monetary stimulus. In Canada, however, employment data have been weak and the consensus 2016 economic growth forecast is considerably lower at 1.9 per cent. The Canadian economy is not well positioned to absorb higher borrowing costs.

There's another problem: Economic growth in Canada, such as it is, is now concentrated in sectors that are negatively affected by higher interest rates. Ms. Enenajor writes, "Fed hikes will tighten financial conditions in Canada [when] Canada's economy is more interest rate sensitive than the U.S. For example, residential investment comprises over 7 per cent of GDP in Canada, roughly double the 3.5-per-cent share in the U.S."

Canada's world famous housing price rally is already showing signs of weakness. The Toronto and Vancouver markets remain red hot but price growth has levelled off in Calgary, Montreal, Winnipeg and Halifax. Rising mortgage rates, or any other type of credit tightening, has the potential to bring the housing party to an end nationwide.

In predicting interest rate convergence, Ms. Enenajor has long-term market history on her side. Importantly, however, the consensus economist view for 2016 indicates that domestic rates will remain well below their U.S. counterparts.

Canadian two-year bond yields (shorter-term bonds are more affected by central bank policy) are expected to climb to 1.04 per cent by the end of 2016 from the current 0.54 per cent.

U.S. Treasury bonds are expected to yield 1.71 per cent by the end of next year, compared with 0.99 per cent now. This means that the spread – the difference in yields between U.S. and domestic two-year bonds – is expected to increase from the current 0.45 percentage points to 0.67 points.

Canadian interest rates may not move up as much as their American counterparts, but Ms. Enenajor's important point remains – they are still set to move significantly higher. Domestic borrowing costs, including mortgage rates, will almost certainly increase at the same time.

The Canadian economy is not collapsing, but remains weak relative to recent years. The sharply lower loonie has yet to generate enough export growth to offset the economic effects of the commodity price plunge. With rising interest rates threatening the housing market, Canadians will hope for another driver of economic growth to appear soon.