The Bank of Canada will be forced to renew warnings of the possibility for higher interest rates in order to halt a "bubble" from forming in the housing market, according to Pacific Investment Management Co.'s Ed Devlin.
Governor Stephen Poloz's removal of language about the potential need to raise rates from the central bank's policy statements has helped to weaken the currency, spurred inflation and contributed to a pickup in exports. At the same time, the rising home prices and debt levels that caused Poloz's predecessor Mark Carney to insert a "hawkish bias" into official statements have continued to climb.
With projected rate increases from the Federal Reserve likely to cause the Canadian dollar to fall further and inflation now at the central bank's 2 percent target, the Bank of Canada will turn its attention back to risks from excessive consumer debt this year or early next, said Devlin, who oversees $17 billion, including the Canadian portfolios for Pimco, the world's biggest manager of bond funds.
"You have an overvalued asset that can correct orderly or disorderly - and the longer we keep rates this low, and the more we accumulate debt the higher probability it gets disorderly," Devlin said at the Bloomberg Canada Fixed Income Conference in New York yesterday. "If Poloz gets his weaker dollar because of the Fed, I think he will become more cognizant of it moving forward."
Canada's currency was little changed at C$1.1192 per U.S. dollar at 8:41 a.m. in Toronto, after touching C$1.1220 yesterday, the weakest since March 24. One Canadian dollar buys 89.36 U.S. cents. The loonie has weakened about 8 percent since Poloz took over from Carney in June 2013.
The Bank of Canada has frozen its key lending rate since September 2010, the longest pause since the 1950s. The central bank's key interest rate will probably remain at 1 percent until the second half of next year, according to economists surveyed by Bloomberg News.
Devlin said Canadian housing prices may be 10 percent to 20 percent overvalued and low interest rates may spur price levels to as much as 30 percent when adjusted for inflation, opening the door to a sharp decline.
"Then you have a swathe of people with negative equity on their house," Devlin said. "You have all the kinds of problems we have down here in the U.S."
This will cause the Bank of Canada to renew warnings about potential interest rate increases in coming months, he said.
Poloz dropped such language from policy statements last October and instead focused on the possibility of low inflation slipping into deflation while stressing how an increase in exports was needed to sustain the recovery and identifying an elevated Canadian dollar as an obstacle to that.
Since Poloz surprised investors by dropping the hawkish bias almost a year ago, the loonie, as the Canadian dollar is nicknamed for the waterfowl on the C$1 coin, has declined about 8 percent.
That's stoked inflation by making imported goods more expensive. Consumer price gains have been at or above the central bank's target rate five straight months and the latest reading from August showed the core rate, which excludes certain volatile items, also above the 2 percent target.
The weaker currency has also boosted the exports Poloz has said the Canadian economic recovery depends on, with the country posting the widest merchandise trade surplus in almost six years in July.
The Teranet-National Bank Home Price Index reached a record reading for August, posting a 67 percent increase since June 2005 with only a slight downturn in 2009's recession. The S&P Case-Shiller index of U.S. home prices is down 8.8 percent over the same period. As the housing market booms, Canadians' ratio of debt to disposable income has started rising again in the second quarter after falling the two previous periods.
"The longer they let this go, the higher it goes, the more it will correct," Devlin said. "If we get the kind of momentum in the short term, I think we're going to see they're going to have to start to recognize that and they're going to turn more hawkish."
Though Devlin doesn't expect the central bank to start raising rates until later next year, the reintroduction of hawkish language will cause bond yields to rise as traders begin to price in a more aggressive rate-increase timeframe. That will cause bond values, particularly in longer dated securities, to fall as yields rise, he said.
"In the short term rates are going to go higher," Devlin said. "You don't fight the central bank too hard, but I do think they'll have to recognize the data."