In its most recent decision, the Bank of Canada (BoC) decided to hike the key policy interest rate by 25 basis points. And despite concerns about the potential impact of further hikes, BoC Governor Stephen Poloz has remained cautiously optimistic that the economy would be strong enough to deal with further increases.
Others might not be so confident, particularly as they watch the Canadian yield curve flatten and threaten to invert. “The Canadian 10-2 year treasury yield spread has being flattening since the start of 2017, narrowing now to sub 0.2%; this is similar to pre-financial crisis levels in 2007,” said ING economists James Knightley and Jonas Goltermann in a new note.
The duo noted that yield-curve inversions have had a good record of signaling recessions, but there have been exceptions in the Canadian case. In the year 2000, Canada and the US both saw inversions, but the ensuing slowdown in Canada didn’t go deep enough to plunge it into recession. And in the case of the 2015 recession that hit the Great White North, there was no preceding inversion.
This could be explained, they said, by Canada’s historical dependence on the oil industry. Oil prices held up decently during the US downturn, and they plunged in 2014. “Canada’s reliance on natural resources (more so than the US) seems to be a plausible reason for anomalous results – those implying an inverted yield curve as a recession-signalling mechanism has its flaws,” they wrote.
Knightley and Goltermann also predicted that the BoC is more likely than not to continue pushing rates higher. There’s the fact that the central bank signalled no intentions of holding back in its October monetary policy report. Aside from that, they cited previous arguments by Poloz that the mechanism behind yield-curve flattening is distorted by “an overwhelming demand for long-dated bonds” driven by the Fed and other central banks since the 2008 financial crisis.
“This, coupled with the BoC pushing policy rates higher, leads to a yield curve flatter than it would otherwise be,” the economists said. Forecasting Canadian 10-year treasury yields of around 3% in both 2019 and 2020, they predicted that the yield curve would invert if the bank were to hike policy rates further into neutral range.
“Solid economic growth, near four-decade low unemployment levels and both core and headline inflation measures on (or above) the bank's 2% target should keep the BoC tightening,” they said. “We predict two further hikes next year, in 1Q19 and 3Q19, and aren’t ruling out a third, albeit subject to downside risks (such as weak wage growth) fading.”
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