What Are The Effects on Canadian Interest Rates And The Loonie From a Fed Rate Hike?

When the U.S. Federal Reserve raises its interest rates for the first time since 2008, the ripple effects will be felt far and wide. The effects could include a lower loonie and how much Canadians pay for loans.

Sooner rather than later, the era of cheap money that has fuelled a strong stock market rally, a still-red-hot Canadian housing sector and the impression that rates have always been this low is starting to come to an end.

That’s because the U.S. Federal Reserve, the most influential central bank in the world, will eventually raise its key interest rate from near zero, where it has been since the 2008 financial collapse.

And that has raised concerns about the knock-on effects of the Fed rate hike in an environment where practically every other influential central bank is holding the line on rates, if not continuing to cut rates (as China did in late 2015 to fire up a sluggish economy). In Canada, the central bank cut rates in January 2015 because of falling oil prices and again in July as a result of a “technical” recession.

Borrowers rightly ask themselves about the effect on Canadian interest rates and on a loonie already battered by the collapse in oil prices.

That is because as the Fed raises interest rates, U.S. Treasuries become more attractive as they pay more return to investors. This in turn boosts the value of the American dollar. It could even push Canadian rates higher as bond markets demand a higher return for lending money to Ottawa.

In Canada, the central bank hasn’t shown any interest in raising its key rate from 0.5 per cent, where it stood at the end of 2015 after two rate cuts during the year aimed at supporting an economy flirting with recession because of oil prices.

But it’s a different story in the U.S, by far the healthiest economy in the world.

“The current Fed policy is inconsistent with the pace of economic growth in the U.S.,” said Paul Taylor, senior vice president and chief investment officer asset allocation with BMO Global Asset Management.

American growth in late 2015 stood at around 2.5 per cent while Canadian growth was coming in at just over one per cent.

He observed that ultra low rates were the correct move when the financial system was in desperate straits in 2008, and were needed to stimulate the U.S. economy.

“But that was then and this is now.”

At the same time, the Fed realizes it has to walk a fine line in hiking rates so as not to upset other global economies. A series of significant rate hikes could also pressure currencies as investors flock to U.S. Treasuries for a higher return.

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But it’s thought that the Fed will continue to be data dependent, observing in particular how the U.S. labour market and the manufacturing sector are performing.

“Every other rate hiking cycle we’ve had with the Fed, it hikes systematically meeting after meeting and I don’t think that will be the case this time around,” said Megan Greene, chief economist at Manulife Asset Management in Boston.

“I think they hike, wait for a while and see the effect on the real economy if economic indicators aren’t looking particularly buoyant.”

The Bank of Canada also relies heavily on economic data in deciding when to hike rates, including the latest on gross domestic product, employment growth and trade.

Analysts also point out that even if the Fed raises its rate half a percentage point to 0.5 per cent, that would merely match the Bank of Canada’s key interest rate.

So, while a limited Fed hike in itself likely wouldn’t force the Canadian central bank to move, there are concerns about how the Canadian dollar could be pushed lower.

It has been badly hammered to a level around 75 cents U.S. (in late 2015) as the economy stumbled in the wake of the oil price collapse. The loonie could come under added pressure because the greenback will likely strengthen as investors can get a higher return from U.S. Treasuries.

But Taylor observed that a limited downward move wouldn’t necessarily be a bad thing.

“A little bit of loonie weakness relative to the U.S. dollar can be good in that it’s the natural stabilizer that allows Canadian product to be more attractive on world trade markets,” he said.

“So a little bit of Canadian currency weakness relative to the U.S. dollar could be a jolt that we need here in Canada to offset oil weakness.”

Greene added that any downward pressure on the loonie could be minimal as markets have already priced in the Fed rate hike.

“But what isn’t priced in is more easing,” she said.

“It’s not just the Fed hike alone, it’s further easing by everyone else, possibly by the Bank of Canada as well. I don’t think that is imminent but it’s also not off the table as well for Canada.”

One way or another, the introduction of higher interest rates in the U.S. will cause a great deal of uncertainty. It’s certainly a good opportunity for consumers to pay off debt while Canadian rates are still very low, and for homeowners to consider locking in at low fixed rates.

3 years ago