Sept. 29 (Bloomberg) -- The gap in Canadian and U.S. benchmark interest rates is at a 15-year high based on the Taylor rule formula for determining optimal rates, signaling borrowing costs are poised to rise further in Canada.
Using the Taylor rule, which measures inflation and output to estimate the ideal interest rate, the Bank of Canada’s benchmark should be about 2 percent, 1 percentage point higher than it is, according to Camilla Sutton and Sacha Tihanyi, currency strategists at Bank of Nova Scotia. The U.S. federal funds rate is 1.75 percentage points above its Taylor rule recommendation, which is below zero.
The combined difference of 2.75 percentage points indicates the two central banks will continue on opposite paths, with the Bank of Canada raising rates and the Federal Reserve providing stimulus, Toronto-based Sutton and Tihanyi wrote in a research note.
The higher rates may halt a rally in Canadian bonds, which have gained for six straight months. Canadian government debt has returned 7.36 percent this year, according to a Bank of America Merrill Lynch index.
“It speaks to the pressure on the Bank of Canada for them to have higher interest rates,” Sutton said in a telephone interview yesterday. “Current policy rates are still too loose, and they’re stimulating the domestic economy, fueling inflation two years down the road.”
The Bank of Canada cut the target rate for overnight loans between commercial banks to a record low 0.25 percent in 2009. As the nation began to benefit from rising demand for its natural resources, the central bank in June became the first in the Group of Seven to raise rates, and has since boosted its benchmark two more times to 1 percent.
Elsewhere in credit markets, the extra yield investors demand to hold the debt of Canada’s companies instead of its federal government ended yesterday at 145 basis points. The spread has tightened 4 basis points, or 0.04 percentage point, in September and the same amount since June 30. Yields fell to 3.64 percent, from 3.95 percent at the end of June.
In the provincial bond market, relative yields tightened to 57 basis points yesterday, from 60 on Aug. 31 and 64 on June 30. Yields were 2.93 percent, little changed from the end of last month. Provincial debt has returned investors 0.81 percent this month, extending the gain this quarter to 3.77 percent and this year to 7.92 percent, which would be the best annual performance since 2002.
Canadian government bonds, with about C$326 billion ($316 billion) outstanding, have returned 0.29 percent percent this month, after reinvested interest, according to another Merrill Lynch index. They gained 2.24 percent in August. U.S. Treasuries were up 0.2 percent this month, compared with a 0.29 percent drop for government bonds globally.
Alberta, Canada’s fourth-most populous province, paid 63 basis points over benchmarks to sell C$150 million in a reoffering of its 4 percent bonds due in December 2019, bringing the total outstanding to C$1.1 billion.
Quebec, the second-most populous province, reoffered C$500 million of its 5 percent bonds due December 2041 at 93.5 basis points over benchmarks. The issue has C$5 billion outstanding.
The Canadian dollar has dropped 2.7 percent this month against a basket of currencies from 10 developed-world nations, the worst performer after the U.S. dollar, yen and pound among the group, according to Bloomberg Correlation-Weighted Currency Indexes. The loonie, as the dollar is sometimes known because of the aquatic bird on the one-dollar coin, has risen 0.8 percent this year.
The Bank of Canada will issue more details tomorrow about its Oct. 6 auction of 10-year bonds. The information will be available on the central bank’s website after 3:30 p.m.
Canada’s 2-year note yield ended yesterday at 1.39 percent, for a yield advantage of 97 basis points over comparable Treasuries, which ended yesterday at a yield of 0.43 percent The spread, which widened to 106 basis points on Sept. 20, the most since July 15, has averaged about 53 basis points in Canada’s favor over 20 years, Bloomberg data show.
John Taylor, an economist at Stanford University, first published his interest-rate formula in 1993. It takes into account inflation and the output gap, the difference between the economy’s capacity and actual output. The rule is widely followed in the economic community, said Michael Parkin, professor emeritus of economics at the University of Western Ontario in London, Ontario, and a member of the Monetary Policy Council at the C.D. Howe Institute, a research group.
According to the estimates of Paul-Andre Pinsonnault, senior fixed-income economist at National Bank of Canada, the country’s benchmark interest rate is 88 basis points below its Taylor rule target, and has been at least 50 basis points below it for nine months, the longest streak since at least 2002. The overnight rate has averaged 3 basis points below its Taylor rule target over those eight years.
The U.S. Taylor rule target has been below zero since March 2009, according to Bloomberg data. The Fed has held its benchmark fed funds rate at a range of zero to 0.25 percent since December 2008. While it can’t cut rates below zero, it can try to stimulate the economy by buying securities, a strategy known as quantitative easing.
The discrepancy between Canadian and U.S. interest rates relative to the Taylor rule means the differences between government bond yields in the two countries are likely to keep increasing in 2011, Scotia Capital’s Sutton said. The yield on the two-year Canadian government bond was 29 basis point higher in January than that on a U.S. two-year note.
The central banks’ separate paths will also be reflected in exchange rates, with the U.S. dollar dropping to 98 Canadian cents by the end of next year, from C$1.03, Sutton and Tihanyi forecast in their report on Sept. 13.
The Taylor rule doesn’t make Canadian interest-rate increases certain. Nine of 13 economists in a Bloomberg survey predict the overnight rate will remain at 1 percent through the year.
“We know the Bank of Canada is still quite prudent and won’t take the chance of raising the rate too high as long as there is the chance the U.S. economy could go back into recession,” said Mathieu D’Anjou, senior economist at Desjardins Group in Montreal. Desjardins estimates the central bank will hold off on an increase until the second quarter of 2011. The Bank of Canada next meets Oct. 19 to determine rates.
From 2001 to 2006, the U.S. central bank allowed its benchmark interest rate to trail the Taylor rule. Critics including Taylor and Parkin said the Fed’s failure to raise rates more quickly contributed to the housing bubble that led to the deepest recession in seven decades.