Divergence in monetary policies (part II)

The yields (or interest rates) of Treasury bonds are tracked by investors for many important reasons. The longer the Treasury bond's time to maturity, the higher the rates (or yields). This makes sense as investors would reasonably demand to get paid more the longer the investment ties up their money. This is a normal yield curve, which is most common, but at times the curve can be inverted which means there are higher yields at lower maturities. In our last post we mentioned we would be discussing the significance of the ten-year Treasury bond yield as an economic indicator, well here it is in a nutshell, it is used as a proxy for many other important financial matters including mortgage rates. It is typically sold by the government and it signals investor confidence. When confidence is high, the ten-year Treasury bond's price drops and yields go higher because investors don’t feel the need to play safe. And alternatively, when confidence is low, the price goes up, as there is more demand for this safe investment and yields fall.

This level of scrutiny means that changes that fall outside the historical range (or dispersion) are said to redefine the economic landscape. It is understood that while the historical range of the ten-year yield does not appear wide, any basis point movement is a signal to the market. Therefore, the ten-year treasury is an economic indicator that tells investors more than the return on investment.

The monetary policy divergence between Canada and United States, where the US Federal Reserve has increased its benchmark interest rate and plans further increases throughout 2017 and Canada has held its central banks benchmark, is said to be taking the driver’s seat as the main driver in the two countries' price action. In fact the Bank of Canada has even indicated that it is prepared to cut interest rates if new US protectionist measures derail Canada’s economy.

The signing of an executive order by President Trump to renegotiate NAFTA has not only added to economic uncertainly but has sparked rumors of a trade war in North America. If Trump were to go forward with these protectionist policies it could trigger a stronger US dollar but then it also would lead to a higher domestic inflation for the US, not to mention retaliation from other countries including Canada. The other option would be for Mexico and Canada to strike individual bilateral deals with the United States.

It’s important to note that the Canadian economy is heavily dependent on crude oil exports; therefore, the CAD has historically enjoyed a strong correlation with crude oil. Keep in mind that Canada is in the third year of the oil price shock, and three years is typically the amount of time needed for such a downturn to run its course. However, Oil prices are expected to remain below US$60 a barrel, and the Canadian dollar could be in for some volatility.

Currently, the danger for Canada lies in its loonies’ correlation with the US greenback. Stephen Poloz, Governor of Bank of Canada, was quoted as having said, “It (the correlation) shouldn’t be as high as it has been” Analyst have concluded that Canada’s dollar strength, imported from the US, is reducing the competitiveness of the country’s exports and creating stress on the Canadian economy. This means that trade will not be the source of economic growth for Canada in the 2017 fiscal year. The potential silver lining for Canada is that Trump is also ending the Trans Pacific Partnership. If Canada decides it wants to participate in that other Pacific trade deal headed by China, it could become the major entry point into the North American market for many products and services and while this will not help the current period in the Canadian economy it will be better positioned in the long run.

For their part the Bank of Canada put out a press release indicating that while core inflation was currently below 2%, they predicted that firmer energy prices would cause inflation to move closer to 2% in the near future and certainly not withstanding any new shocks projected that inflation should hit its target of 2% in the latter part of the year.

In addition to inflation woes, trade speculations and geopolitical uncertainly, the Canadian housing market has been playing a crucial role in the Canadian economy. Unfortunately, economists are predicting a steep and widespread downturn in the Canadian housing market for 2017.

By,

Kaha Haji-Mohamed

Works Cited

Picture titled, "United States Federal Reserve System", taken by Kurtis Garbutt on November 20, 2011, obtained through Creative Commons (https://flic.kr/p/aLbWnT