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

The happy times of cheap money are drawing to a close as the U.S. Federal Reserve finds it increasingly difficult to justify keeping its key rate near zero. This could mean that Canadian consumers and companies will also find that borrowing is more expensive.

Canadian borrowers, both corporations and consumers, had it pretty good from the time of the 2008 financial crisis. That’s because both camps have had the benefit of being able to access ultra-cheap money after central banks around the world rushed to slash rates to near zero to stave off economic collapse.

But those happy times of cheap money will eventually draw to a close.

That is because global bond markets ultimately call the tune when it comes to how much the Canadian government and corporations end up paying to borrow money. And that in turn can spill over to consumer borrowing.

And going into 2016, the U.S. Federal Reserve is finding it increasingly difficult to justify keeping its key rate at 0.25 per cent since economic conditions have improved greatly since those dark days of ’08 and their aftermath.

“The reality is the overnight rate in the U.S. has been at a quarter of one per cent for an awfully long time, since December 2008,” observed Brian Carney, a vice-president at Canso Investment Counsel.

“And since that time, many things have changed. The unemployment rate, which was over seven per cent, went to almost 10 per cent – today it’s down to five per cent. So a lot has changed, the economic situation we think in the U.S. has dramatically improved.”

And the first knockon effect from such a move by the Fed is for international investors to take a good hard look at the situation in Canada.
“When they compare Canada to the U.S., we think they will start to realize that things are a little bit tougher in Canada than they are in the U.S. and that rates in Canada should start to rise and that would be irrespective of what the Bank of Canada does,” said Carney.

The Canadian economy is grappling with the effects of the collapse in oil prices, worries that great chunks of domestic real estate are inflated and a manufacturing sector in Ontario and Quebec that continues to sputter, despite a Canadian dollar that has gone down in value alongside oil prices.

On top of that, the two big eastern provinces continue to add to their already large deficits.

Despite this economic disparity, the Canadian government was able to issue debt at a cheaper price than what the U.S. government has to pay – a situation that has certainly not escaped the notice of the bond markets, which after all determine what a company or government pays for borrowed money.

For example, in late 2015 the U.S. Treasury 30-year bonds were yielding about three per cent while Ottawa could issue similar debt for about 2.3 per cent – something that Carney finds unsustainable.

“There is a huge disconnect we think when the Canadian government can borrow money at a substantially lower rate than the U.S. Treasury – so we think that if nothing else happens, even if the Fed doesn’t raise rates we think the positive economic situation in the U.S. and the somewhat negative economic situation in Canada warrants that Canadian interest rates move higher,” he said.

“We think they could at least go to parity with the U.S. and quite frankly we think they should be higher than the U.S.”

So, while consumers and corporations will both likely be paying more to borrow, it is companies that are likely better prepared for this eventuality than the average consumer who thinks that cheap money has always been available and always will be.

“I think one of the realities is corporations, both Canadian and U.S., to some degree have been expecting an increase in interest rates for a long period of time so there has been an awfully large amount of financing, call it pre financing, done in the markets in anticipation of interest rates going higher,” Carney noted.

However, there could be some nasty surprises for the consumer, including those holding the large mortgages that have become a fact of life for Canadian home ownership.

That is because fixed rate mortgages are calibrated off five-year government of Canada bonds, and if those move higher, then ultimately mortgage rates will go higher.

Consumers may find themselves a bit confused, thinking they can take their cues from the Bank of Canada. But it’s the bond market that will ultimately determine rates.

Think of it this way. The Fed raises interest rates, making U.S. government bonds more attractive because the investor makes more money. That could result in the marketplace demanding a higher yield from those Canadian government five-year bonds and that in turn will put upward pressure on fixed mortgage rates.

People with floating rate debt, such as money borrowed for lines of credit and floating rate mortgages, would be safe for a little while. But only until the Bank of Canada feels that it must raise its key overnight rate, which stood at 0.5 per cent in late 2015.

But ultimately when that rate goes higher, that will have a knock on effect to anyone who has borrowed in the floating rate market. And that applies to individuals and corporations.

5 years ago