May 15, 2018 / 7:42 PM / 2 years ago

Rising U.S. yields clip Bank of Canada's control over borrowing costs

TORONTO (Reuters) - The Bank of Canada appears to be losing sway in its own backyard as bond yields there chase after rising U.S. interest rates even though Canadian policy makers have pledged to proceed slowly with rate hikes of their own.

A sign is pictured outside the Bank of Canada building in Ottawa, Ontario, Canada, May 23, 2017. REUTERS/Chris Wattie

That’s a problem for a Canadian economy that has been powered in large part by record consumer debt on home mortgages, and evidence of a slowdown in home sales and credit growth is already emerging as borrowing costs surge.

Sales of existing homes fell to a five-year low in April, data released Tuesday showed, while the inventory of unsold homes was the highest since 2015. Meanwhile, annualized household credit growth in March slowed to 3.44 percent, a seven-year low, and mortgage loan growth slid to a three-year low.

Consumers are not the only ones feeling the pinch. Non-financial corporate bond issuance has dropped by more than a third in the year through April from a year earlier, according to Thomson Reuters data, and Canadian industrial corporate bond yields as tracked by Bank of America/Merrill Lynch have hit their highest in four-and-a-half years.

Analysts and investors see U.S. rates markets as the culprit behind the quickened pace of financial tightening in Canada.

“A concern for the Bank of Canada is that rising U.S. rates will drive up term interest rates in Canada more than it would want with its domestic monetary policy,” said Ed Devlin, head of Canadian portfolio management at Pacific Investment Management Co.

The U.S. Treasury market has long had outsized influence on bond yields worldwide because of its size and the U.S. dollar’s status as the primary global reserve currency. Its sway over Canadian market rates is even more pointed, however, because of the close economic ties between the two countries.

The Federal Reserve has raised interest rates six times since December 2015 to a target range of 1.50 percent to 1.75 percent and has projected three hikes for all of 2018, although some economists and investors are banking on four increases this year.

By contrast, the BoC has raised its policy rate just three times since the start of the current cycle in July 2017, most recently to 1.25 percent. It has promised to proceed with caution from here, and that has led markets to price in no more than two more hikes this year. BOCWATCH

But that has not slowed the rise in Canadian bond yields as their U.S. counterparts march higher.

Canada’s 5-year yield CA5YT=RR, closely watched as a benchmark for mortgage interest rates around the country, is at a seven-year high above 2.30 percent. The same maturity of U.S. Treasury notes US5YT=RR, meanwhile, are at their highest yield since 2009 at 2.91 percent as benchmark U.S.-10 year note US10YT=RR yields have broken above the key 3 percent level.

As a measure of the degree to which Canadian bond yields are detached from the BoC’s policy rate CADISC=, the Canadian 5-year note’s yield now stands 106 basis points above the BoC rate compared with about 53 basis points a year ago. That is the widest spread in nearly five years.

Last month Toronto-Dominion Bank lifted its posted rate for five-year mortgages by 45 basis points to 5.59 percent even as the BoC stayed on hold. Some of the other major Canadian banks have since lifted their posted rates.

The increases come as nearly half of outstanding mortgages face a rate reset within the year, according to BoC estimates from late 2017.

“Financial conditions in Canada are tightening perhaps more aggressively than the Bank of Canada anticipated,” said Karl Schamotta, director global markets strategy at Cambridge Global Payments.

Bank of Canada Governor Stephen Poloz cautioned in a speech earlier this month of the risks to the economy from record high household debt. It rose in the fourth quarter to more than C$2.1 trillion, about 170 percent of disposable income.

“Every rate hike that we can see from them will have a greater impact on the economy because leverage ratios are so high,” said Andrew Kelvin, senior rates strategist at TD Securities.

And the BoC’s slipping control will grow ever more evident.

“The Bank of Canada never really had full control over the borrowing costs that consumers and corporations were facing, it has just becoming more apparent now that we are starting to see a bit of divergence between Fed policy and Bank of Canada policy,” Kelvin said.

Reporting by Fergal Smith; Editing by Dan Burns and Phil Berlowitz

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