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Financial Markets weekly newsletter

Posted on: December 30, 2016

The stats sheet

  • 3 mos CDOR – .94 bps
  • 2 year GOC bonds - 0.76%
  • 5 year GOC bonds - 1.13%
  • 10 year GOC bonds –1.74%
  • 3 mos US libor - .998
  • 5 yr Treasuries - 1.96%
  • 10 yr Treasuries - 2.48%
  • USD/CAD – 1.3435
  • EUR/CAD – 1.4180
  • CAD/JPY - 86.93
  • GBP/CAD – 1.6613

George Santayana is credited with saying, “Those who do not learn history are doomed to repeat it.”

I considered this when reading numerous predictions for Canadian and US rates for 2017. Most appear to believe that US rates will rise next year and Canadian rates will not. After all, the BOC is on hold and the Federal Reserve are in tightening mode. Hard to argue with. However, as my old Management Accounting professor Murray Bryant is fond of saying, “that’s factually correct, but not very useful.”

What we really need to consider are two things; 1) The extent of the moves and the forward looking prediction for rates in to 2018 as the 2017 changes evolve, and 2) The differential between the US and Canadian rates all the way down this curve.

And this is where Mr. Santayana comes in. A quick look at the recent history** of Canadian and US rates differentials sees that the discount in Canadian rates to US rates, seen in the yield curves and the FX forward points, appears to base out at between 50 and 100bps.

Taking the 2 year rate as a proxy for the full curve and the market tone, In 2000, with rates in the 6 to 7% range (remember that?), it peaked briefly at 100bps. In 2008, before the Fed got very aggressive with its cuts in H2, it peaked at 100bps (rates were 1.5% versus 2.5% approximately). In 2005, with rates in the 4% range, the “wide” was 50bps. Currently, it is around 50bps ( 1.10% versus 1.60%).

Markets currently have 55-60bps of hikes from the Fed in 2017 priced in. In Canada, it’s a token 9bps, all in Q4. Those 9bps, most analysts suggest, are out of sympathy more than anything else. Right now, that seems a reasonable comment. But it wouldn’t take much for this writer to raise a Spockian eyebrow at that opinion and quote Mr. Santayana in 2017. Simply put, if one feels that the Fed have telegraphed their moves well and will be successful in predicting the future so accurately that the market is perfectly priced at 2-3 hikes, then history would suggest that its possible that the BOC will find just cause in not reacting, (as the market currently suggests).

However, does anyone really believe that the Fed can be so accurate in predicting? I am not sure even the Fed does. If they are being overly optimistic, then it’s likely we get 1-2 hikes, and the BOC will likely sit tight. But if, as some believe, we are poised for a growth and inflation story- then the Fed may react more aggressively to in H2 2017 and H1 2018 (the new administration would certainly not object to that). If so, take my advice—don’t listen to anyone telling you that the BOC would hold Canadian rates in that scenario. History would suggest that they will be proved wrong.

**I have examined 35 years of data but am somewhat discounting history pre-2000. Rate cycles were more volatile and actual rates so much higher that the differentials had much greater capacity to move. Even then, Canadian rates were only through US in a more meaningful way in just 1997.

A happy and prosperous 2017 to all our readers. Our sincerest thanks for your attention.

We at Financial Markets remain, as ever, All In.

Mark Johnson
Director, Financial Markets-Interest Rate Sales



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