In the fall of last year, I suggested an out of consensus view that interest rates in Canada would fall quicker and by a greater degree relative to American interest rates.  Well, it took longer than I expected, but the “tail of two cities” scenario” I eluded to between Canada and the U.S. that I suggested would unfold, is in fact happening!  I don’t always get it right by any means, but I’ll pat myself on the back for this one!

The Bank of Canada (BoC) lowered its policy rate by 25 basis points on June 5, joining the Swiss National Bank and Sweden’s Riksbank as the first G10 central banks to cut interest rates this year. The BoC gave limited guidance on future rate cuts, but RBC Capital Markets and Bloomberg consensus expect the overnight rate will be lowered to four percent by year-end from five percent at the start of the year. These same sources expect further rate reductions in 2025. That path would see the BoC diverging from its U.S. counterpart, with the timeline for Federal Reserve rate cuts having been pushed back by elevated inflation readings and generally firm economic data. This divergence is justified, given the softer growth backdrop in Canada and more benign inflation trends. Canada’s economy is clearly feeling the effects of higher rates, while in the U.S., there is ongoing debate over the neutral interest rate and whether monetary policy is sufficiently restrictive.

Though uncommon, policy rates between Canada and the U.S. have diverged in the past. In the mid-1990s, stubbornly high unemployment and fiscal consolidation in Canada necessitated greater monetary policy support from the BoC. The Fed lowered its policy rate by relatively more following the dot-com bubble when the U.S. experienced a mild recession while Canada avoided a downturn. A less extreme but more sustained divergence occurred following the global financial crisis, which caused a deeper recession in the U.S. that was followed by a period of household deleveraging and fiscal restraint.

Today, the market seems to imply we are in for another extended period of policy divergence. The spread between 10-year U.S. Treasury (UST) and Government of Canada (GoC) yields is at its widest level in at least several decades. It’s even wider than the 2-year spread, which is influenced more by near-term monetary policy.

Justification for the divergent interest rate policy seems logical.  Unlike the U.S., Canada didn’t go through a deleveraging cycle post the global financial crisis. Rather, Canadian households continued to accumulate debt, pushing the country’s debt-to-disposable income ratio to a record high and close to the U.S.’s 2008 peak on a comparable basis. Today, the average Canadian household has about 20 percent more debt than its U.S. counterpart, adjusted for income. On top of a higher debt load, Canada’s economy has seen faster pass-through of rate hikes due to the prevalence of 5-year fixed and variable rate mortgages, as opposed to 30-year fixed rates that are common in the U.S. While the U.S.’s debt servicing burden has barely budged amid policy tightening, Canada’s household debt service ratio has increased to a record high. And only half of Canadian mortgage holders have had to refinance at higher rates so far, according to the BoC. While Canada’s debt-to-income ratio has flattened out in recent years, the deleveraging process will be a slow process as the economy attempts to “grow into” high levels of household debt. That suggests Canada’s greater rate sensitivity is likely to persist for the foreseeable future. Just as the Fed kept monetary policy more stimulative for several years amid the deleveraging following the global financial crisis, the BoC might have to keep interest rates lower relative to the Fed for an extended period as Canada deals with its own debt overhang

Mike Candeloro, Senior Portfolio Manager and Wealth Advisor with RBC Dominion Securities and the head of The Mike Candeloro Wealth Management Group supplied this article. RBC Dominion Securities Inc. and Royal Bank of Canada are separate corporate entities, which are affiliated. Member CIPF. Mike can be reached at Michael.candeloro@rbc.com   You can also visit his website at www.michaelcandeloro.com or on LinkedIn.  To read Mike’s archived articles please visit Mike Candeloro / Special to The Nugget | National Post