LINDA LINFOOT'S BLOG ON INTEREST RATES - INFORMATION FROM THE ROYAL BANK OF CANADA
Interest rates will be lower than we thought in October
Our reassessment of the financial market risks facing the U.S. economy has led us to revise down our forecast for U.S. rates in late 2007 and 2008. In the near-term, we expect interest rates to trade at the lower end of their trading range with a 3.75% 2-year yield and 4.35% 10-year rate forecast for year-end 2007. This is a change from our October forecast which looked for 2-year yields to rise to 4.15% and for 10-year rates to increase to 4.65% by the end of 2007. Much of this downward revision to our rates forecast stems from the persistent nervousness in financial markets about the impact of the US subprime mortgage market’s degeneration on other credit products.
We are still forecasting that US interest rates will rise in 2008 though the bulk of the upward movement occurs in the second half of the year as the U.S. economy reaccelerates and the Fed begins to reverse the rate cuts. We forecast US growth will average 2.8% in the second half of 2008, faster than the 2% in Q4 2007 and the average 2.5% quarterly pace of the first half of 2008. Our forecast calls for the two-year UST yield to rise to 4.85% at yearend 2008 with the 10-year rate at 5.20% with the Fed raising the Fed funds rate by 50 basis points in the fourth quarter to 4.75%. This compares to our October forecast of a 2-year rate of 5.25% and the 10-year rate of 5.35% and a Fed funds rate of 5%.
Bank of Canada likely to lower overnight rate in early 2008
The Bank of Canada presented an even-handed assessment of the risks to the 2% medium-term inflation target in their Monetary Policy Report on October 18. In their report, the bank pointed to Canada’s economy operating beyond its capacity limits, resulting in a shift into excess demand, which is generating upward pressure on prices. However, the bank also pointed to downside risks emanating from the strong Canadian dollar, the slowing US economy and slightly tighter credit conditions concluding that “the risks to the inflation outlook are balanced although with a slight tilt to the downside.”
We expect that the domestic demand will remain firm backed by the improvement in the terms of trade (as export prices continue to outperform import prices), recent tax cuts, the strong labour market and historically low interest rates. However, the continued deterioration in the US housing market and sky-high Canadian dollar are inflating the downside risks to the outlook for Canadian exports. Since the October 16, the cut-off date for the Bank’s Report, the Canadian dollar has gained an additional 4.5% and this morning touched its highest level in the post-war period of US$1.0710, running about 8% above the US$0.98 level assumed in the Bank’s forecast.
Canada’s dollar still has some upside potential and will likely continue to appreciate into early 2008 leading to softer demand for Canadian exports and resulting in the trade sector acting as a more significant drag on the pace of Canadian growth. The trade drag is likely to be greater than the Bank assumed in its October forecast and we expect will eventually prompt an easing in interest rates to offset this restraint. We expect the Bank to cut the overnight rate by 25 basis points in the first quarter of 2008 and have adjusted lower our forecast for Canadian interest rates accordingly.
We now expect Canadian interest rates to trade at the low end of their recent range, ending the year at 4.10% for 2-years and 4.25% for 10-year yields. In early 2008, the 25-basis point cut in the overnight rate to 4.25% is likely to see short-term rates move modestly lower. Our expectation that the US economy will reaccelerate in the second half of 2008 will likely see the US dollar regain ground against it major trading partners, with the Canadian dollar likely to drift back down through parity. This will take some of the sting out of the trade sector’s bite on Canadian growth and will give the Bank room to reverse its early 2008 rate cut.
We still expect interest rates in Canada to grind higher in second half of 2008 but have trimmed back our forecast to 4.5% in 2-year rates (from 5.00%) while maintaining our previous forecast of 5.05% 10-year rates at yearend. The 2-year Canada/US spread is forecast to narrow from +35 basis points at the end of 2007 to -35 basis points by the end of next year with the Canada/US 10-year spread holding in a -10 to -20 basis point range.