Why Canada's interest rates will rise later and more slowly than America's

Three reasons Canada won’t simply mirror the U.S. on interest rates

Since the global financial crisis in 2008, both Canada and the U.S. have had exceptionally low interest rates. The debate, however, has more recently turned toward when interest rates will start to rise, and how quickly they will rise.

At Leith Wheeler, where I work, the view is that interest rates in Canada will rise both later and more slowly than in the U.S.

The U.S. Federal Reserve will likely start hiking rates in June 2015, followed by the Bank of Canada (BoC) in December 2015. The Fed will likely raise rates by 2.75 percentage points (bringing the rate from 0.25 per cent currently to 3 per cent) by the end of 2017, compared to just 1.75 percentage points in Canada (bringing our rate from 1 per cent to 2.75 per cent) over the same period.

There are three primary factors behind the view that interest rates in Canada will probably rise later and more slowly. First, Canada’s higher levels of private-sector debt. Second, a preference for a weaker currency to boost exports. And finally, our relatively higher exposure to global economic risks.

Arguably, the main reason for Canada to raise rates later is our relatively higher level and duration of household debt. Household and non-financial corporate debt is significantly higher in Canada than in the U.S. And the sensitivity of that debt to changes in interest rates is also much higher in Canada, primarily as a result of the prevalence of fixed-rate mortgages in the U.S. As a result, the impact from changes in rates has a stronger effect in Canada than it does south of the border.

Secondly, the BoC wants to lag the Fed in terms of rate hikes to deflate the Canadian dollar and therefore support Canada’s exporters.

Bank of Canada Governor Stephen Poloz has made several remarks recently that suggest the BoC would prefer a weaker currency. Last August, when U.S. rate markets were starting to more aggressively price rate hikes from the Fed, he said, “The main thing people should understand is that our policy is quite capable of being fully independent [from the United States], as it has been these past few years.” In mid-October, he said he wasn’t alarmed about a situation in which the Fed’s key rate could exceed Canada’s.

Although Leith Wheeler agrees with Poloz—that the BoC is not explicitly targeting a currency depreciation or level—it does appear that Canada’s central bank views currency weakness in the near-term as a key tool in achieving its 2-per-cent inflation mandate.

Finally, the BoC will likely be slower than the Fed in raising rates because of the Canadian economy’s relatively higher exposure to the global economy’s potential for a slowdown in growth. In the U.S., exports account for roughly 13 per cent of GDP, compared to 30 per cent of GDP for Canada.

Due to the recent deterioration in the growth outlook in Europe and several emerging market countries, Canada’s larger share of exports will likely have a relatively larger “negative” impact on Canadian growth. For that reason, the BoC is likely to be more cautious about raising policy rates than the Fed.

Ben Homsy is a member of the fixed income team at Leith Wheeler Investment Counsel in Vancouver. Forward-looking statements are based on assumptions, and outcomes could differ materially.