How Fed Liftoff Could Sink the Last Bastion of Canadian Growth
Policymakers at the Bank of Canada have reason to be cheerful as they sit down at their meeting starting today.
Figures released this morning show the Canadian economy grew at an annualized rate of 2.3 percent in the third quarter, bucking declines in growth in the first and second quarters of this year. The boost will come as a relief to central bankers who have been contending with a dramatic oil rout that has undercut one of two engines powering Canada's impressive stretch of economic growth since the financial crisis of 2008. Yet potential trouble is emanating some 2,000 miles south of the BoC.
In two weeks, Federal Reserve policymakers will be gathering for a meeting that's widely expected to result in the first U.S. interest rate increase in almost a decade. Fed Chair Janet Yellen now threatens to upset the final bastion of Canadian growth as the U.S. central bank's normalization process risks derailing the interest rate-sensitive segments that have been propping up the Canadian economy for years in the face of sluggish external demand.
"Canada’s economy came through the financial crisis on relatively firmer footing than the U.S., but it did so by relying on residential investment and household debt, the same sources of growth that created large headwinds for the U.S. during the financial crisis of 2008-09," Macquarie Analyst David Doyle wrote in research preceding Tuesday's GDP figures. "While we don’t anticipate a U.S.-style housing market 'crash' in Canada over the next two years, we do believe that the stretched levels create headwinds for Canada’s growth rate" in the future.
The Federal Reserve is laying the groundwork to inch rates higher for the first time in nearly a decade, and the possibility of negative spillovers to emerging market economies has been cited as a potentially destabilizing force for the global economy. But if Americans want to see how the Fed’s tightening bleeds through to other economies, they needn’t look farther than their neighbor to the north and biggest trading partner, to see how changes in financial markets driven by U.S. central bank policy affect real activity outside its borders.
For Canadians, the most pressing issue is whether financial or economic linkages will dominate in the wake of a hike from the Federal Reserve. The yield on Canadian sovereign debt isn’t determined in a vacuum and, depending on its maturity, can be heavily influenced by international forces—chiefly, those emanating from the U.S.
“Five years is sort of the middle ground, the pivot point where both U.S. and Canadian trends come into play,” explained CIBC World Markets Chief Economist Avery Shenfeld, referring to five-year Canadian government debt. “The 10- and 30-year [yields] tend to be dragged by the U.S., and under two-years is driven by the Bank of Canada.”
Parsing U.S. liftoff
U.S. liftoff was once viewed as a time in which accelerating demand for Canada’s goods and services would more than offset the mixed effect on financial conditions. The loonie would presumably depreciate relative to the greenback while importing some of the U.S.'s rising yields. If U.S. demand fails to get stronger, however, Yellen could be serving Canadians an all-vegetable dish without the courtesy of a dessert. What were thought to be countervailing forces stemming from Fed normalization may prove to be a net negative for America’s neighbor to the north if growth doesn't materialize.
In Canada, the five-year government bond yield is the primary channel whereby changes in monetary policy affect household borrowing. That's because, unlike in the U.S., the dominant mortgage product north of the 49th parallel is the five-year fixed rate home loan.
The five-year Government of Canada bond yield isn’t necessarily an accurate reflection of banks’ funding costs, but when it’s on its way up, you can be sure it’s the excuse that lenders and monolines will point to when explaining why households are facing higher mortgage rates.
So far, the Bank of Canada has been winning this all-important battle. Five-year Canadian bond yields are significantly below their U.S. equivalents, with the yield premium an investor received for buying a five-year Treasury rather than Government of Canada bond hitting nearly hit 1 percentage point in July.
Concrete proof of monetary policy divergence—the Bank of Canada’s surprise rate cut in January, which caused market participants to rapidly recalibrate the path for short rates—is the proximate cause of this North American sovereign debt divorce, as monetary stimulus was supplied in an effort to shield the Canadian economy from the oil price shock.
As such, the current spread can be viewed as a signal that financial markets are accurately reflecting weaker economic linkages between the two countries.
“After a 20-year flow of Canada becoming more tightly linked to the U.S. economy in the lead up to the Free Trade Agreement and then Nafta, linkages are still very close but have become a little less tight lately because of Canada’s rising reliance on commodities,” said Douglas Porter, chief economist at the Bank of Montreal.
But the spread was unable to break into new highs when North American monetary policy divergence was in full bloom. That theme has since faded—market participants see the Bank of Canada and Federal Reserve marching in the same direction, though at different times. Overnight index swaps suggest the Bank of Canada's overnight rate is more likely to be higher than lower at the end of 2016.
And going back to the onset of the Great Moderation, the U.S. five-year has failed to sustain a yield premium of 100 basis points for any substantial amount of time. Since mid-1989, the correlation coefficient between Canadian and U.S. five-year debt is 0.91, implying that the two tend to move in the same direction more than nine times out of ten.
"It's not within the Fed's mandate to worry about our problems," said Brian DePratto, an economist at Toronto-Dominion Bank. "As they start to tighten, the direction is clear: you are going to see that pass through to the Canadian five-year."
In other words, Canadian five-year yields are going up; it's only a matter of by how much.
A rebalancing of growth toward exports has long been a goal of Canadian policymakers, and categories highlighted as sensitive to exchange rate fluctuations have outperformed since the loonie’s descent. But the ability of exports to drive meaningful Canadian growth has deteriorated.
“Non-energy exports to the U.S. comprise about 15 percent of Canada’s nominal GDP,” wrote Macquarie’s Doyle. “While this is significant, it is only about half the share it was just 15 years ago.”
Make no mistake about it: Low rates—or more accurately, the lack of higher rates—have a lot to do with why the two quarters of negative growth Canada endured to open 2015 weren’t more severe.
“The stars of the show this year have been housing and auto sales, the classic interest rate sensitives,” said BMO’s Porter. “I dare say no one at the start of the year would’ve predicted the strength we saw in many housing markets, [housing] starts rising, auto sales at record highs.”
A look at the offsets
Labor market strength in the housing sphere is best evidenced through the robust growth in sales-related jobs. Real estate and leasing—a subgroup that represents less than 2 percent of total employment across the nation—has been responsible for 18 percent of net job growth in 2015 and accounted for more than 90 percent of employment gains through April, during a period in which regional economies were adjusting to the harsh realities of the oil shock.
Although the numbers do not provide sufficient color in this regard, it’s not difficult to envision an Albertan becoming a landlord, or attempting to orchestrate the sale of his or her property after being let go from an oil sands project.
The six-month trend for housing starts is above 200,000, exceeding the level justified by underlying demographic demand. But will this be the latest proof of the Canadian construction boom’s seemingly perpetual resilience, or its death rattle?
“Housing starts will be slower two years from now even if there’s no interest rate hike by the Bank of Canada,” predicted Avery Shenfeld, chief economist at CIBC World Markets. “That channel to stimulate growth has been used up, and the result is that the only channel left is that lower rates can help keep the currency down.”
Shenfeld’s remarks speak to a broader theme: the concept of pulling forward demand, with low interest rates facilitating the purchase of homes or cars by people who would not have done so otherwise.
Pulling forward demand in interest rate-sensitive segments of the economy has been an explicit goal of stimulative monetary policy and been implied in targeted fiscal measures deployed in the Great White North.
Elevated aggregate household indebtedness is, to a certain extent, proof that Canadian policymakers have been successful in boosting domestic demand. Conversely, it also represents a growing stock of accumulated vulnerabilities.
The prolonged nature of these victories brings ever closer the day in which the marginal buyer is conspicuous by omission and pulling forward demand becomes a policy bug rather than a feature.
“If you’re pulling forward demand at a time in which you’re poised to have a structural downturn in growth, there’s very much a risk associated with that,” said DePratto, calling the potential for a void in demand a constant concern. “From a financial stability standpoint, if you pull too much demand forward, then you’re setting yourself up for a larger fall later.”
The increased vulnerability to the onset of a household deleveraging process as the cost of servicing debt rises is why the five-year spread between American and Canadian sovereign debt is the most important chart for residents north of the border to watch as we head into 2016. Most economists expect this gap to continue to widen while simultaneously acknowledging that Canada will be hard-pressed to avoid importing tighter financial conditions in the form of higher interest rates.
At this level, interest rate fluctuations clearly have an asymmetric effect in Canada depending on the direction. The extended duration of the low interest rate environment has buoyed interest rate-sensitive segments, and it's unclear whether these parts of the economy could be doing more to support growth, or if policymakers would even deem that to be an ideal outcome.
On that note, there is a valid argument to be made that the Canadian economy—battered but not broken—after the collapse in oil prices, is actually well-positioned to pull off a so-called "beautiful deleveraging process." Action from the Fed could actually help in this regard.
“From the Bank of Canada’s point of view, a little bit of tightening of credit conditions may not be unwarranted,” said TD’s DePratto, noting that a moderation in the growth of debt at the household level is far from policymakers’ worst nightmare.
The service sector, for instance, receives a huge competitiveness boost, thanks to the softness in the loonie, and has much less of a need for imported machinery and equipment to expand operations than have manufacturers, for which the weak currency serves as headwind on investment.
In the absence of a rebound in oil prices, slower growth that allows for a reduction in household imbalances would appear to be the sustainable—though not particularly exciting—best case scenario for the Canadian economy.
But Canadian policymakers, be they monetary or fiscal, have limited influence when it comes to engineering such an outcome. The Bank of Canada’s peers south of the border—and market participants’ reaction to its action or lack thereof—may end up driving the trends that dictate the destiny of its largest trading partner.
Bank of Canada Governor Stephen Poloz and his colleagues at the central bank are attempting to tailor monetary policy to the nation's needs. The task becomes all the more daunting at a time when Janet Yellen seems increasingly comfortable using the fundamentals of the U.S. domestic economy—not the international backdrop—as her guiding light.