Market mayhem puts Canadian rate hike on back burner

grant robertson — BANKING REPORTER

From Tuesday’s Globe and Mail
Published Monday, Aug. 08, 2011 7:19PM EDT
Last updated Tuesday, Aug. 09, 2011 7:04AM EDT

Deepening financial turmoil in the United States and Europe has all but derailed Bank of Canada Governor Mark Carney’s plans to raise interest rates this fall.

Less than a month after Mr. Carney began hinting interest rates would be going up soon, the market is now betting against such a move. Trading activity in money markets indicates that many investors now believe his hands will be tied until at least the end of the year, and possibly into early 2012.

The growing threat of another economic slowdown has left the Bank of Canada with little choice but to put off planned hikes for fear of damaging the recovery further, market watchers say. That means temporary relief for homeowners concerned about a jump in their monthly mortgage payments, but it also means low returns on savings and deposits. Low interest rates are usually a symptom of tepid economic growth.

Uncertainty surrounding the U.S. debt crisis, spurred this week by the market fallout over the downgrade in the country’s debt rating, and ongoing fears over financial instability in Europe, are the key factors behind the sudden change in interest rate expectations.

“Whatever rate hike expectations you had over the next year deserve to be scaled back in the context of what’s happened,” said Eric Lascelles, chief economist at RBC Global Asset Management. “Europe has intensified, and the economic recovery is looking both less certain and less promising than it was a few weeks ago, and certainly a few months ago.”

Bankers’ Acceptance futures, contracts that represent where investors believe short-term interest rates are going, traded significantly lower on Monday. The most stark signs of the trend were seen in December contracts, which were trading at a yield of 0.85 per cent on Monday – sharply below the Bank of Canada’s benchmark overnight rate of 1.00 per cent.

That suggests the market believes interest rates could go lower by the end of the year. Near-term, the September contracts were also trading lower, at 1.09 per cent. Though above the benchmark rate, the rate suggests few market participants believe interest rates are going up next month.

The Bank of Canada has held its overnight interest rate at 1 per cent since last fall, and was poised to revisit an increase on Sept. 7. Boosting rates to tighten credit in Canada has been seen as one of the next steps Mr. Carney would take to control inflation and return the country to a more normal monetary policy.

“I think it’s clear that there are a lot of serious problems still in the world and it’s more likely that we’re setting the stage for a sustainably low level of interest rates for a very long time – and that the initial tightening by the Bank of Canada [last fall] was unnecessary,” said Peter Gibson, chief portfolio strategist at CIBC World Markets.

In fact, Mr. Gibson added, the possibility of rates being lowered is now more realistic than before.

Economists believe there is little Mr. Carney and Finance Minister Jim Flaherty could do to manage around the U.S. and European turmoil, so holding off on rates is effectively a decision to sit on the sidelines.

“The Bank of Canada has made some overtures in recent statements, suggesting that it is nearing tightening [raising rates],” Mr. Lascelles said. “If we’d been talking a few weeks ago before the latest downturn, I think that something like October would have looked pretty good.”

But much could change given the volatility of the markets. The sovereign debt woes of the U.S. and Europe have flared up just as Canada is producing mildly promising economic data in certain pockets of the economy. July’s employment report, which was released on Friday, was stronger than expected.

“As we’ve seen, markets can swing and perception can swing quite aggressively, and we could well be back to a fall expectation [of a rate hike] in a month’s time,” Mr. Lascelles said. “But at this point it’s probably safer to say either very late 2011 or early 2012 is perhaps where the thinking deserves to be.”

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