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analysis

Ottawa feels your pain when it comes to soaring interest rates. Or at least, it will feel your pain fairly soon.

In their April budget, the federal Liberals touted the benefits of their strategy to issue longer-term bonds in order to lock in low interest rates. But that debt-management strategy is only a partial and, in some cases, temporary protection from the bite of higher rates.

Partly that’s because Ottawa has taken its focus away from issuing longer-term bonds, and instead is resorting to shorter-term issuances, according to the plan laid out in the budget.

In fiscal 2021-22, 10-year bonds accounted for 31 per cent of gross bond issuances and 30-year bonds accounted for 11.8 per cent. But both shares are forecast to decline in this fiscal year, with 10-year bonds making up just 25.5 per cent and 30-year bonds, 7.6 per cent. (The dollar value of gross issuances is also projected to decline, meaning those long bonds take up a smaller slice of a shrinking pie.)

Taking up the slack are shorter-term bonds, particularly two-year issuances, whose share is forecast to jump to 34.9 per cent this year from 26.3 per cent last year.

It’s not hard to see why Ottawa was tempted to move in that direction. In the weeks leading up to the early April budget, the average yield for one- to three-year bonds was significantly lower than for 10-year bonds. But that relationship flipped in early July, with the yield of those shorter-term issuances now dozens of basis points higher than the 10-years. (One basis point equals 1/100th of a percentage point.)

What does this mean for the federal budget balance? The April budget contains some guidance – and a bit of an unintentional bad omen.

The budget outlines the impact of a sustained increase in all interest rates of 100 basis points. Key in that last sentence is the word “sustained.” A spike of a week or a month won’t make too much of a difference.

That caveat aside, the numbers are this. A 100-basis point increase in interest rates adds $5.1-billion in costs in the first year, rising to $6.9-billion in the fifth year. Simplistically, the 300-basis point increase in the Bank of Canada’s benchmark rate this year would seem to indicate that around $15-billion in debt-servicing costs is slated to land on Ottawa’s bottom line.

But reality is more complex. To start with, the same inflationary pressures that are pushing the central bank to hike interest rates are also inflating Ottawa’s revenue. Critically, the federal government’s sensitivity estimates don’t take that factor into account.

Plus, Ottawa was already forecasting some increase in interest rates. The budget forecast that the average yields on three-month treasury bills would rise to 0.8 per cent in calendar 2022, up from 0.1 per cent in 2021. The average 2022 yields on 10-year bonds were forecast to rise to 2 per cent, up from 1.4 per cent last year.

So far, however, those estimates are turning out to be far short of the mark. As of Aug. 30, the yield on three-month treasury bills was 3.32 per cent, 252 basis points higher than the average yield in the budget.

There is a similar story for 10-year bonds. As of Sept. 7, their yields stood at 3.13 per cent, 113 basis points higher than the budget.

It bears repeating that those spot figures aren’t directly comparable to the average yields in the budget. Still, it’s hard to believe that the rise in interest rates is just a spike. That just means that it is a matter of time before those shorter-term securities roll over and are replaced by more expensive versions.

As for that omen: The budget’s discussion over sensitivity to interest-rate hikes provides detailed modelling. But that modelling is limited to a 100-basis point increase. It seems that today’s 300-basis-point reality – and likely more – was either inconceivable or unpalatable to the Finance Department.

Taxing questions

Responding to a recent Tax and Spend about the debate over marginal effective tax rates, one online reader contended that the federal child benefit would not fall if a recipient increased their income.

That’s true only in the short term. Eventually, that increased income will indeed trigger a clawback in Canada Child Benefit payments. For payments made from July, 2022, through to June, 2023, the Canada Revenue Agency uses (adjusted) net family income from 2021.

So, yes, an increase this year won’t immediately lead to a reduction in benefits. But come next July, it most certainly will.

Line Item

Inflation revolution: The Bank of Canada is getting this inflation thing all wrong, argues the Montreal Economic Institute. In a report issued last week, the institute says that the most widely publicized measure of inflation, the change in the consumer price index over the past 12 months, is not an accurate reflection of cost pressures in the economy. A more accurate measure would be the compounded, annualized rate, the MEI writes. In short, that would calculate what inflation would be over the next year if the current month’s rate were to persist for the next 12 months.

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