Interest rates seen rising in September

(August 25, 2004) It has become something of a foregone conclusion that the Bank of Canada will soon tighten interest rates, but the question remains: How fast and how far will rates go?

At a meeting earlier this week of the Canadian Association of Business Economists in Kingston, Ontario, Bank of Canada deputy governor David Longworth hinted that the bank would start tightening credit at its next policy meeting on September 8. In July, the Bank of Canada left its key overnight lending rate unchanged at 2%, but earlier this month, the U.S. Federal Reserve boosted rates 25 basis points to 1.5%.

Longworth pointed to Canada’s GDP growth, which hit an annualized rate of 5% in the second quarter — a full 1% over the bank’s target. Inflation, however, has yet to kick in according to data released this morning by Statistics Canada. Excluding energy, the consumer price index remained at 1.6% in July.

But the central bank wants to make sure inflation stays under control.

“It’s a very reasonable scenario that the bank will raise interest rates, come September,” says Benjamin Tal, senior economist at CIBC World Markets. “The relative softness in the U.S. and the strong Canadian dollar, to me suggests that even if they start moving in September, the overall increase will be fairly limited.

He says CIBC World Markets is expecting rates to rise by only 75 basis points by the end of 2005, so hikes in 2004 will likely be few and far between.

While the soaring price of crude oil has driven the overall consumer price index higher, Tal says the drag that higher energy costs imposes on the rest of the economy will actually have a deflationary affect.

With oil prices appearing to be under control, recently backtracking from record highs near $50 US per barrel, the risk of deflation seems to subsiding. But the Bank of Canada will likely tread carefully.

So what do slowly rising interest rates mean for the fixed income portion of your clients’ portfolio?

“I think the bond market has been factoring in too much bad news over the past month or two and I think we are due for a correction,” he says. “These kinds of comments will work to help the bond market. I think over the next month or two we’ll see yields rising a little bit.”

For the near term, Tal says short bonds will likely outperform long bonds over the next two or three months. After that, he says the yield curve will flatten and long bonds will become more attractive holdings.

“The main improvement will be early next year, when you will see the long end of the curve improving much faster than the short end, and we will see a flattening of the yield curve.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com