Canada's 'pancake' yield curve threatens productivity, credit growth

TORONTO (Reuters) - Canada’s productivity and credit growth face a threat from a flattening yield curve as it makes it less appealing to invest in long-term projects, and lesser still if the Bank of Canada meets its goal of a 3 percent interest rate.

FILE PHOTO: Canadian Loonies, otherwise known as a one dollar coin, are displayed on top of an American currency in this posed photograph in Toronto, Ontario, Canada, October 10, 2008. REUTERS/Mark Blinch/File Photo

The gap between 2- and 10-year yields, a benchmark measure of the yield-curve slope, has slumped in Canada to about 13 basis points. That is the narrowest since the global financial crisis and about half of the equivalent U.S. spread.

Further narrowing of that spread could reduce the incentive for banks to lend and hinder investment in the multi-year projects that tend to boost the speed at which an economy can grow, economists and fund managers said.

GRAPHIC: Spread between 2- and 10-year yields -

The Bank of Canada last week raised its key interest rate to 1.75 percent and said the rate will need to rise further to a neutral stance of about 3 percent to achieve its inflation target.

“If that is where they think neutral is, they will have a yield curve as flat as a pancake,” said Darcy Briggs, a Calgary-based portfolio manager at Franklin Bissett Investment Management. “Banks borrow short and lend long ... if they borrow at the same rate as they lend out, what motivation do they have to extend credit.”

While the Bank of Canada helps determine the level of short-term rates by its policy setting, it is the expectations for growth and inflation that have greater influence over the long end of the yield curve.

A flat yield curve could lure investors to make short-term bets and crimp investments in far-reaching projects, such as new technology, that often boost productivity, raising the potential growth rate of an economy.

“It discourages risk taking because people can get a pretty decent rate of return by keeping their money pretty liquid,” said Sal Guatieri, senior economist at BMO Capital Markets.

Investors tend to demand a higher return for the greater risk of tying up money for longer, known as a term premium.

But in Canada, the term premium has been depressed more than elsewhere by low global yields and scarcity of long-dated bonds, said Andrew Kelvin, senior rates strategist at TD Securities.

There is a “reasonable chance” that the curve would invert if the Bank of Canada lifts interest rates as high as 3 percent, Kelvin said.

Yield curve inversion, where long-term rates fall below short-term rates, has traditionally been seen as a harbinger of recession. But its reliability as a signal may have been weakened by factors such as global central banks buying bonds, the Bank of Canada said last week.

Still, the gap between Canadian and U.S. long-term rates, of as much as 88 basis points in favor of U.S. bonds, could be starving Canada of some of the capital it needs to boost the growth rate of its economy.

“It is almost like a vicious cycle, where right now investors, for whatever reason, foresee weaker long-term growth in Canada than in the U.S., competitiveness reasons for example, and so that money is flowing to the U.S.,” Guatieri said.

Reporting by Fergal Smith; Editing by Denny Thomas and Susan Thomas