Trade tensions lower investors' sights for Bank of Canada terminal rate

TORONTO (Reuters) - Investors are betting that Bank of Canada interest rate hikes will peak before they reach the central bank’s estimate of neutral, as rising trade tensions and high domestic debt loads threaten to slow the growth of the country’s economy.

FILE PHOTO: Bank of Canada Governor Stephen Poloz walks to a news conference in Ottawa, Ontario, Canada, April 18, 2018. REUTERS/Chris Wattie/File Photo

The neutral rate is seen as the sweet spot for monetary policy, where it neither boosts nor restrains growth.

Failure to reach neutral would indicate the economy is not where it should be going into the next downturn. It would also leave the Bank of Canada with less ammunition to fight that slowdown.

“There is a sense that growth in Canada isn’t going to be sufficient enough to bring the Bank of Canada back to neutral in a timely fashion,” said Andrew Kelvin, senior rates strategist at TD Securities.

The central bank has raised its benchmark interest rate three times since last summer to 1.25 percent, with investors expecting another hike as early as next month.

But the rate where it is then expected to peak, called the terminal rate, over the coming years is around 2.25 percent, data from 3-month Canadian bankers’ acceptance futures (BAX) and Reuters calculations showed, falling short of the central bank’s neutral rate estimate of between 2.5 percent and 3.5 percent.

The Bank of Canada declined to comment.

The potential for Canada’s economy to be unable to handle much more tightening is also reflected in the spread between Canadian and U.S. short-term yields. Canada’s 2-year yield fell further below its U.S. equivalent on Wednesday to a spread of -71 basis points, its widest since March 2007.

Hosen Marjaee, senior managing director, Canadian fixed income at Manulife Asset Management, estimates the interest rate cycle will end at 2 percent. He flags slow-moving talks to revamp the North American Free Trade Agreement and trade disputes between the United States and other major economic regions, such as China and Europe as “top of the list” of risks for Canada’s export-dependent economy.

Investors also worry about heavy borrowing by Canadians in recent years that contributed to an overheated housing market. Rising interest rates and the introduction in January of tighter mortgage rules are beginning to show signs of strain on highly indebted Canadian consumers.

Consumer spending decelerated at the start of the year for the third straight quarter, according to Statistics Canada.

James Athey, senior investment manager at Aberdeen Standard Investments in London, worries that wages will not keep pace with rising debt service costs just as house prices fall, so that consumers then retrench.

“The Canadian economy is far more interest rate sensitive than it used to be,” Athey said, who has bought short-term Canadian debt on the expectation that the Bank of Canada will tighten less than the market anticipates.

Reporting by Fergal Smith; Editing by Cynthia Osterman