Skip to main content

The trajectory of the Canadian economy depends on interest rates. With a housing market that looks more and more like a bubble and record levels of household debt, a sharp rise in the cost of borrowing would cause immediate and lasting damage to economic growth.

What are the odds of an interest-rate-led financial cataclysm in 2014? Any attempt to answer this question depends on the reality that Canada is a "yield-taking" country with interest rates largely determined by the U.S. bond market. Therefore, prognosticators must answer two questions: What will U.S. Treasuries do? And how will the Bank of Canada react?

Right now, many investors fear that prices for U.S. Treasury bonds will collapse after the Federal Reserve tapers its monetary stimulus. Falling bond prices would mean much higher interest rates, because the two move in opposite directions.

A collapse in Treasury prices, thankfully, is highly implausible. Economic fundamentals suggest the U.S. government bond market is much more fairly priced than a lot of investors believe. A crash is unlikely, even in the event of a more rapid than expected Fed taper.

Historically, the yield on a 10-year U.S. Treasury yield has been closely aligned with the growth of nominal GDP. The most recent U.S. gross domestic product data show year-over-year nominal growth of 3.3 per cent. The current U.S. 10-year Treasury yield is 2.85 per cent, about 45 basis points below GDP growth. So U.S. Treasuries are roughly in line with GDP growth and any post-taper bond market sell-off should be limited to about 50 basis points.

What about Canadian bonds? Canadian government yields move with U.S. yields even during periods when, on the surface, this makes little sense. The U.S. Federal Reserve is not our central bank, and yet Government of Canada bonds suffered right along with Treasuries when taper fears began. Between March, 2013, and now, U.S. 10-year yields climbed 100 basis points and Canadian 10-year yields rose 81 basis points.

This recent lack of independence in the Canadian bond market is entirely typical. The average difference between Canadian and U.S. 10-year rates is a scant 26 basis points over the past two decades despite periods where the respective economies were growing at vastly difference speeds. The difference right now is 17 basis points, which is well within historical norms.

So to sum up: There is no major bond market adjustment that needs to be made. U.S. 10-year yields are in line with GDP growth and Canadian yields are tracking the U.S. bond market. This suggests that U.S. nominal GDP growth will be the major determinant of yields for both countries in 2014.

The base case for 2014 – an acceleration of U.S. economic growth with Canada's economy following close behind – is positive for both investors and the Bank of Canada. In that scenario, the negative effects of higher yields would be offset by greater economic activity. Rising interest rates and the subsequent higher mortgage payments could also persuade domestic households to decrease debt levels, providing longer-term economic benefits during a period of aggregate growth.

The danger is that Canadian GDP growth lags that in the U.S. by a big margin. Because Canadian bond yields follow Treasuries, and Treasuries follow nominal U.S. GDP, higher interest rates would be imported to Canada through the bond market. This sets up the potential for a downward spiral with rising rates providing a brake on economic growth when it's slow already. In this case, the Bank of Canada would be forced to cut interest rates and risk further expansion of the household debt bomb.

The Canadian and U.S. economies are so closely tied through trade that the optimistic scenario of faster growth and slightly higher interest rates on both sides of the border is the most likely course of events for next year.

There are, however, potential wild cards out there – for instance, a hard landing in China that would hit the resource-based Canadian economy far harder than the U.S. one – that could make 2014 a very difficult year for Bank of Canada policy makers.

Follow related authors and topics

Authors and topics you follow will be added to your personal news feed in Following.

Interact with The Globe