The sharp rise in long-term interest rates in the past four months indicates how much the clouds of uncertainty that weighed on financial markets in January have dissipated.
A large part of that uneasiness started to evaporate earlier this year when U.S. Democrats and Republicans negotiated their way around the so-called “fiscal cliff” – simultaneous tax increases and spending cuts that threatened to derail economic growth in that country. As well, the gloom in Europe seems to be lifting as the major European economies inch their way out of recession, plus and China’s economy appears to have avoided a hard landing.
All that has set the stage for stronger economic growth in 2014 – 2.5%-3% in U.S. and about 2.25% in Canada, economists say, following this year’s lacklustre 1.6%-1.7%. This situation, in turn, has so encouraged financial markets, they have bid up long rates, with the U.S. 10-year bond rate closing at 2.92% on Sept. 11, up from 1.94% on May 21 – the day before U.S. Federal Reserve Board chairman Ben Bernanke told Congress that the Fed expected to start reducing monetary stimulus before the end of this year.
Although economists didn’t anticipate the sharp rise in long rates, they weren’t surprised. “Negative real long rates didn’t make sense,” says Doug Porter, chief economist and director, economics, with Bank of Montreal in Toronto.
Carlos Leitao, strategist and chief economist with Laurentian Bank of Canada in Montreal, agrees: “There was no reasonable rationale for rates to be so low. Rates below 2% are only consistent with looming deflation.”
Economists expect long rates to stay around these levels until the Fed actually starts reducing its purchases of financial assets, although rates could dip if alarm bells go off. For example, negotiations to increase the U.S. debt ceiling, which will be reached around mid-October, may well go into the 11th hour, raising fears that the U.S. wouldn’t be able to pay its bills.
Underlying economic growth is stronger in the U.S. than in Canada because of the differences in the housing markets. The U.S. housing sector collapsed in the wake of the 2008 global credit crisis but now is firmly in recovery mode, albeit from a very low base; Canada’s market started cooling only recently.
In addition, American consumers have reduced their debt levels since 2008 and are now in a position to spend; however, Canadians have continued to add to their borrowing and need to deleverage.
What’s similar in both countries is government restraint, which will keep U.S. economic growth relatively moderate and add to the negative factors in Canada.
Here’s a look at the two economies in more detail:
– Canada. With sluggish consumer spending, a cooling housing market and government restraint, exports are the best bet to drive growth. And the stronger growth expected in the U.S. could help to provide that boost.
The question is how much strength exports can provide, given the erosion of Canadian manufacturers’ competitiveness and the resulting disappearance of many firms after years with the Canadian dollar worth above US90¢. Automobiles, for example, are a major Canadian export, but most of the growth in production in that business sector is occurring in Mexico and the U.S. south.
“The story on autos is about adding value through electronics, a game we’re not in,” says Warren Jestin, senior vice president and chief economist at Bank of Nova Scotia in Toronto. And, he adds, the big sales growth will come in Asia and Latin America, markets Canada doesn’t serve.
Another factor, says Krishen Rangasamy, senior economist with National Bank of Canada in Montreal, is the “right to work” legislation in U.S. states. That’s reducing unions’ bargaining power and pushing down wages, which makes Canadian manufacturers less competitive in those markets.
Resources are, of course, major exports. But lumber is the only commodity likely to see strong increases in demand and prices as U.S. housing continues to improve.
Metal and mineral prices are still at high levels. But growth in China and other emerging markets is moderating, so demand is expected to be only strong enough to keep prices where they are. Craig Alexander, senior vice president and chief economist with Toronto-Dominion Bank (TD) in Toronto, notes that with costs of production “up materially” in the past decade, margins could be squeezed.
The story for oil prices is similar, although geopolitical risk can push up prices, as happened recently due to the conflict in Syria.
– The U.S. Housing and consumer spending are expected to carry the ball. The question is how much momentum they’ll create, which depends on consumer confidence – and that, in turn, depends on the unemployment rate.
There’s been a bigger decline in the jobless rate than had been expected, but the downward trend could stall because much of the drop is coming from low participation rates. (There are fewer Americans looking for work now than before the credit crisis.) Rangasamy points out that participation is now at the lowest level in 35 years. As “discouraged” workers start seeking jobs, they will once more be counted as unemployed.
The question is how many discouraged workers will return. Alexander is assuming an increase in the participation rate in TD’s forecast but “not to anywhere close to pre-recession levels.”
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