Manager Insight

"Sensitivity to changes in rates is much higher" for Canadians.
By Michael Ryval | 08/01/15

An accelerating economy will prompt the U.S. Federal Reserve to raise interest rates in mid-2015, but the Bank of Canada's response to a growing GDP will come later and at slower pace, says Ben Homsy of the fixed-income team at Vancouver-based Leith Wheeler Investment Counsel Ltd.

About the Author
Michael Ryval, a regular contributor to Morningstar, is a Toronto-based freelance writer who specializes in business and investing.

"The Bank of Canada will follow about six months after the Fed, in December 2015," predicts Homsy, whose firm oversees about $17 billion in assets, including $4 billion in fixed income. "The initial move will be 25 basis points (bps) by both central banks. But the more important question is the pace of interest-rate hikes. We expect interest rates to go up slowly, in comparison to previous tightening cycles. We've pencilled in the Fed to raise rates by a total of 275 bps by the end of 2017, and the Bank of Canada to raise rates by 175 bps in the same time frame."

A 17-year industry veteran who hails from Sydney, Australia, Homsy argues that the Bank of Canada will be cautious about the pace of rate hikes, for three reasons. First, he maintains that the level of household indebtedness is holding back the central bank and is, in fact, a tacit acknowledgement of higher sensitivity to rate hikes than in the U.S.

"People think the U.S. is a more leveraged economy. And that was the case in the lead-up to the financial crisis," says Homsy. "But we've noticed there has been a relatively significant amount of deleveraging in the U.S., with households paying down debt and mortgages. It's brought debt as a percentage of GDP to the low 80% level, from close to 98% in 2009. That deleveraging has not occurred in Canada at all. In fact, the Bank of Canada has referenced it in recent policy statements."

Homsy notes that Canadian household debt as a percentage of GDP has risen to about 95% from 90% in 2009. "We see this as a risk. But it's one of the reasons why it would be harder for the Bank of Canada to raise rates as aggressively as the Fed."

In addition, Homsy points to the structure of the underlying debt, which tends to be comprised heavily of mortgages that are usually shorter-term in nature. Many mortgages, in fact, are based on floating rates. In contrast, U.S. mortgages are long-term in nature, allowing for greater predictability and stability. "The point is the sensitivity to changes in rates is much higher in Canada because of the underlying debt structures."

The second reason revolves around the Canadian dollar. Stephen Poloz, governor of the Bank of Canada, who formerly headed the Export Development Corp., has repeatedly stated that the central bank targets inflation, and not the exchange rate. "However, the Bank of Canada has also highlighted the importance of the export sector in the recovery of the Canadian economy. It wants to see job creation in the export sector as a precursor to raising interest rates," says Homsy.

"The best way to help the export sector is through a weak Canadian dollar," says Homsy. "And the most effective way to weaken the currency is through a narrowing of the short-term interest-rate differential between the U.S. and Canada."

The third reason concerns the fact that Canada is more exposed to global economies, with exports representing about 30% of GDP -- a proportion that is more than twice as large as in the U.S. "A stronger global economy would have a larger positive impact on Canadian growth, while a weaker global economy would have a larger negative impact," says Homsy, who before joining Leith Wheeler in 2014 spent seven years at Goldman Sachs and five years at JP Morgan Chase, in both cases working in currency hedge-fund sales.

"When we look at what is happening elsewhere in the world, there are signs of weaker growth in Europe, slowing growth in emerging economies such as China, Brazil and Russia and mixed success so far in Japan," says Homsy. "Our economy is more prone to an adverse global background (than the U.S.)" By inference, he adds, the Bank of Canada will be more cautious about raising rates than the Federal Reserve.

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