Canadian bonds, loonie brace for U.S. Federal Reserve rate hike

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The U.S. Federal Reserve is all but certain to increase its key interest rate this week for the second time in three months, raising concerns that bonds and the Canadian dollar will be walloped.

"We still think that investors are underestimating how quickly the [Fed] will raise rates in the second half of this year and beyond," John Higgins, chief markets economist at Capital Economics, said in a note.

According to Bloomberg, markets believe there is a 100-per-cent chance that the Fed will raise its key rate by a quarter of a percentage point when it announces its decision on Wednesday. These odds are up from about 50 per cent at the end of February.

Officials can take credit for the rising odds: Fed chair Janet Yellen said earlier this month that a rate hike "would likely be appropriate." Last month, she noted that the economy is "near maximum employment."

The latest U.S. employment figures, released Friday, supports this view. Employers added 235,000 jobs in February, well above the 200,000 jobs that economists had been expecting, sending the unemployment rate down to 4.7 per cent.

"If there was any doubt about the Fed acting, Friday's employment report sealed the deal," Michael Gregory, an economist at BMO Nesbitt Burns, said in a note.

Investors have been anticipating higher U.S. interest rates ever since Donald Trump won the U.S. presidential election in November, sending yields on U.S. Treasury bonds sharply higher and causing all sorts of mayhem on fixed-income investments.

The yield on the 10-year U.S. Treasury bond surged to 2.6 per cent in mid-December, up from 1.8 per cent before the election. That marked the sharpest increase in seven years, according to Bloomberg.

As a result, bond prices – which move in the opposite direction to yields – have been falling, weighing on popular exchange-traded funds that provide exposure to the bond market. The iShares 7-10 Year Treasury Bond ETF, for example, has fallen about 6 per cent since November, which is a big move for bonds.

Canadian bonds have been affected, too. The yield on the Government of Canada five-year bond has nearly doubled since the U.S. election in November, to 1.27 per cent.

The anticipation of U.S. rate hikes – and a sidelined Bank of Canada – has hit the Canadian dollar. The loonie has fallen close to 74 cents against the U.S. dollar, down more than 2 cents in the past two weeks. If the Fed suggests this week that it is going to continue to raise its key rate as the year progresses, there may be more pain ahead for the loonie and fixed-income investors.

Economists at Toronto-Dominion Bank expect the Fed will raise rates three times by the end of 2017.

"From the purview of the Fed, the objective of full employment is being met. As further proof, tighter labour markets are resulting in wage increases meaningfully outstripping inflation," TD's Beata Caranci and James Orlando said in a recent note.

Capital Economics expects four rate hikes this year. They also forecast that the yield on the 10-year U.S. Treasury bond will rise to 3.5 per cent – up nearly a full percentage point – which offers a strong reason for investors to avoid government bonds.

However, the future is hardly clear-cut. Some of the optimism for the U.S. economy rests on the Trump administration introducing tax cuts and a trillion-dollar infrastructure spend, but neither plan has been accomplished yet.

As well, it remains to be seen what Mr. Trump says about rate increases if they undermine his vision of much stronger economic activity. While the Fed is independent of the White House, Mr. Trump has shown himself capable of trampling such distinctions.

He can also make it clear that he will not reappoint Ms. Yellen to a second term as Fed chair – a policy decision that could be announced in the summer.

Finally, there is the uncertain role of currency. The U.S. dollar index, which compares the greenback with a basket of major currencies, is close to a 14-year high. That raises the cost of imports and makes U.S. exports less competitive, neither of which is good for the economy.

"U.S. dollar strength has arguably done the Fed's tightening work for it," Derek Holt, head of capital markets economics at Bank of Nova Scotia, said in a note earlier this month.