Last week the Bank of Canada (BoC) raised its policy overnight rate by 50 basis points (bps) to 1.0%. This was its second policy rate hike announcement over back-to-back meetings and shows we are well underway with another rate hiking cycle. Since the BoC adopted the overnight target rate as its primary monetary policy tool back in 1994, there have been six previous distinct tightening cycles as shown in the table below. Of the thirty-four rate hikes since June 1997, only five have been larger than 25bps with last week’s announcement being one of them. A 50bps rate hike is unusual and validates the zeal with which Governor Macklem wants to normalize monetary policy as quickly as possible.
Source: NBF Economics & Strategy, BoC, QV Investors
In the quarters leading up to their initial rate hike announcements this year, both the Bank of Canada and the U.S. Federal Reserve had been lethargic in tightening monetary policy. Admitting that inflation had been running below their 2% target for an extended period, they knew they would have to tolerate higher price pressures to make up for some of that lost ground from prior years. Additional patience seemed warranted especially with so much uncertainty stemming from the pandemic. However, with Canada’s consumer price index (CPI) hitting a multi-decade peak of 6.7% year-over-year in March (strongest pace since 1991), we are likely to see additional 50bps rate hikes from the BoC in upcoming months as it now realizes it is behind the curve.
Market expectations were revised to reflect a faster BoC hiking path and higher overnight policy rate, repricing Government of Canada bond yields as a result. In its April 2022 Monetary Policy Report, the BoC disclosed that its estimate for the nominal neutral rate in Canada (the estimated rate that will support the economy operating at full capacity with inflation back at the 2% target) was amended 25bps higher to a range of 2.0% to 3.0%. The economic theory suggests that somewhere in this range lies the ideal interest rate that will balance aggregate supply and demand, resulting in optimal economic expansion. Our intention is not to debate this theory but to show that the BoC wants to bring its policy rate up to this range as soon as possible to tame price pressures. Now if the BoC can hike its policy rate to the midpoint of this range (2.50%) by the end of the year, this would imply a change of 225bps (2.50% – 0.25%) over a period of ten months (Mar to Dec). At 22.5bps per month, the pace of this hiking cycle has the potential to be the fastest we have seen from Ottawa.
As we know, markets are forward-looking and central bank governors have clearly signalled their intentions to return policy rates back to neutral. Given this, and that recent inflation readings are coming in at multi-decade highs, market expectations have priced in a ~3.0% BoC overnight rate by the end of 2022. This is well above the prior cycle’s peak rate of 1.75% in 2018 and is on the high side of the BoC’s neutral range. Markets typically tend to swing between extremes so whether we may ultimately see a 3.0% overnight rate is still up for debate.
We know inflation is well above average and that the labour market has fully recovered, but Canadian households are more indebted than ever. In fact, Statistics Canada reported that household credit market debt as a proportion of household disposable income was 186.2% in the fourth quarter of 2021, the highest level on record. Higher policy rates lead to higher mortgage rates, and the higher cost of borrowing in the face of elevated debt levels increases the probability of a policy misstep. We do not have a crystal ball, but simple math suggests that a 3.0% BoC policy rate could result in a 5-year fixed mortgage rate of approximately ~6%. At that level, housing affordability will be a much different picture than what we have grown accustomed to. We have not seen 5-year fixed mortgage rates with a six handle since 2007 to 2008 and given elevated debt levels, it is difficult to envision the BoC holding its policy rate there for an extended period.
The upward climb in bond yields (and resultant lower bond prices) have been tough to swallow but we are optimistic of the higher return potential that current yields offer going forward. For example, high quality investment grade corporate bonds are currently offering 4% to 5% yields. We have not seen these rates of return for a long while and have purchased both government and corporate bonds at these better valuations, improving the bond strategy’s yield to 3.8% as of this week. Fixed income continues to be the ballast in a balanced portfolio, offering diversification during times of market stress and finally some decent income that investors can earn in the meantime. We have prepared the bond strategy with higher income earning potential and defensive characteristics. We are hopeful that the BoC can achieve the soft landing that it aspires to but are also prepared for a policy error if that scenario unfolds. As we know from studying past hiking cycles, taking the punch bowl away is no easy task.