The U.S. Federal Reserve raised interest rates this Wednesday December 14, 2016 by only a quarter-point—from 0.50% to 0.75%, but now, for the first-time since 2007, Canada will have a lower central bank rate than its southern neighbour.
Last week, the Bank of Canada announced it would stay the course on its own monetary policy by continuing to hold its target rate at 0.5%. In the announcement, the BoC stressed that their decision was based on the possibility of an economic slowdown (or, at least, continued anemic economic growth).
“Following a very weak first half of 2016, growth in the third quarter rebounded strongly, but more moderate growth is anticipated in the fourth quarter,” said the bank, which is led by governor Stephen Poloz.
Eight times a year, the Bank of Canada sets its key interest rate. This is a fancy way of saying it establishes an overnight target interest which is then used by banks to set the prime rate. This prime rate establishes how much it will cost to borrow, whether it’s a mortgage, a car loan or any other type of loan or debt.
So what will it mean to have divergent monetary policies in the U.S. and Canada? Here are six answers to your questions.
No. 1: How will this affect Canada?
Normally, Canada and the U.S. have monetary policies that move in similar directions. If U.S. interest rates go up, Canada’s rates will typically follow. But today’s announcement marks an important deviation from this norm—a phenomenon known as divergence.
Poloz addressed the global trend of divergence way back in January 2016. He wrote: “At one end of the spectrum, the U.S. Federal Reserve has just started its interest rate normalization process after seven years of keeping its policy rate near zero. At the other end, the European Central Bank (ECB) recently cut its deposit rate to negative 0.3%. Other central banks also cut rates in the past year, including the Bank of Canada.”
According to Poloz the reason for the divergence is that these monetary decisions “simply reflect actions taken by central banks tailored to their own economies.” Our very own BoC governor also warned us earlier this year that the underlying forces within the global economy are slow movers: “This means that the theme of divergence—both financial and economic—is likely to remain with us for some time to come.”
At the end of this year, this pronouncement certainly rings true. The U.S. economy grew at an annual rate of 3.2% by the third quarter—its fastest rate in two years. The job market is also booming (for now), with the jobless rate dropping to a nine-year low of 4.6%.
In Canada, our economic picture isn’t as optimistic. We’re still growing, but at an anemic rate—with a year-end forecasted growth rate of just 1.1%. Our job growth is also less than stellar, with part-time positions dominating the growth numbers.
No. 2: Does this mean higher interest rates in Canada?
Not yet. That’s because the Bank of Canada (BoC) has one primary focus: The overall economic health of our nation. To do this they must balance economic growth with employment. The method for achieving this goal is through the use of monetary policy. Monetary policy refers to the measures taken by the BoC to influence the economy by regulating the amount of money in circulation. In other words, it’s how the BoC tries to control the amount of money that flows in and out of Canada’s economy (both nationally and internationally).
The BoC’s main tool is by setting the overnight target interest rate. If the Bank of Canada raises its overnight rate, it will cost more for your local big bank to borrow. To recover these costs, banks raise their rates for all types of loans, including mortgages and lines of credit. If the overnight rate decreases, bank’s will look to compete for your business prompting interest rates to drop.
No. 3: Where will the impact be felt, first?
Based on the past, we know that the initial victim of today’s U.S. Federal Reserve announcement will be the loonie. In 2015, the BoC cut the benchmark rate twice in 2015, in an attempt to stimulate the economy, yet when the U.S. Feds finally hiked its rate in December (after six years at record lows) our dollar lost 16% of its value.
The BoC’s announcement last week, that it will hold the overnight rate, is a strong signal: Our national bank is content to allow the Canadian dollar to weaken. Poloz provided insight into this decision earlier this year, when he stated that our nation’s central bank runs its own, “independent monetary policy, anchored by our inflation target of 2%.”
The loonie’s decline in value is just one aspect of our nation’s global economic footprint which includes our ongoing struggle with lower oil prices. In a speech BoC Governor Poloz gave in Ottawa at the start of 2016, he explained that a weak loonie is the result of weak prices for Canada’s commodities, in particular oil. As a result, the depreciation of Canada’s currency “is a natural part of the process.”
The good news is that the Canadian dollar strengthened in the last week, posting a near eight-week high on Tuesday. It’s the result of higher oil prices. Still, with the divergence between U.S. and Canadian monetary policies, the low loonie is likely to stay, at least for the foreseeable future.
While a lower loonie certainly creates economic challenges for Canada’s economy (and higher grocery bills for Canadians), there are some winners. For instance:
→ Tourism will boom: One area that has an almost immediate impact is on tourism. Americans may find it enticing to spend their vacation and shopping dollars north of the border if their greenback gains more traction.
→ Investors with U.S. holdings rejoice: If you’re nest egg includes U.S. equities, you’ll get an extra bang for your buck. Not only have U.S. stock outperformed Canadian stocks, as of late, but converting your earnings back into Canadian dollars will be juiced by the exchange rate.
→ Foreign buyers may come back: The cheap dollar could entice Americans to continue (or renew) shopping for Canadian real estate, particularly in popular resort and vacation spots such as Canmore, Alta., Whistler, B.C., Muskoka, Ont. and in the Maritime provinces.
No. 4: Will mortgage rates rise?
The reason why Canadians are interested in what the U.S. Federal Reserve does is because U.S. interest rates affect long-term interest rates in both U.S. and Canada. Even though fixed-rate mortgage rates aren’t traditionally impacted by changes to the overnight rates—fixed-rate loans move in tandem with 10-year bond yields—an increase in overnight rates will put pressure on mortgage rates. Since fixed-rate mortgages move in tandem with the yield of the 10-year U.S. Treasury note, the key factors to consider are: inflation, market fluctuations and investor sentiment.
Typically, raising short-term interest rates will help stave off inflation. This combined with the BoC’s commitment to follow its own monetary policy, borrowers could be forgiven for thinking that Canadian fixed-rates for mortgages won’t rise. But that’s not the case.
Bond markets move up and down far more frequently than the prime rate (which follows the overnight rate, set by central banks); quite often bond market rates move on a daily basis. So, if the market sentiment decides it doesn’t like a few factors, such as a decision to follow a divergent monetary policy, continued slow global economic growth, a world-wide aging population, and the swearing in of Donald Trump as the next American President, we could be see a rise in bond rates, which will absolutely start to increase fixed-rate mortgage rates.
As TD’s Senior Economist Leslie Preston pointed out in a recent note:
In the here and now, inflation remains relatively benign, but financial markets have ratcheted up their expectations for future inflation in the wake of Trump’s election victory. Anticipation that Trump will pursue expansionary fiscal policy, and potentially raise import tariffs, have been behind rising inflation expectations. It remains to be seen how the President-elect’s policies will play out, but there is little doubt that the direction for inflation is higher.
No. 5: What about variable-rate mortgages?
On the other hand, Canadian variable rates probably won’t change, just yet.
But like fixed-rate mortgages, the U.S. Fed target will have an impact. The direct consumer impact will be on U.S. variable-rate mortgage holders (as well as all those that hold other variable-rate tied debts, such as credit cards, auto loans and lines of credit). But this could, eventually, impact equity market returns. That’s because these American consumers will have less disposable income. Less money spent on goods and services will eventually hurt the revenue and profit of businesses, which will impact stock market returns. Also, higher loan costs can potentially decrease business spending, which can also slow down economic growth, decrease profit and hurt future market returns.
Still not all stocks perform badly when borrowing costs rise. For instance, rate hikes can be particularly positive for financial sector holdings.
No. 6: Really, what does this mean for me?
The bottom line: Not a lot. The Fed only hiked its benchmark overnight rate by 0.25%. This won’t shatter budgets or destroy business balance sheets. But should the Fed continue to hike its target rate in the coming months and years, all borrowing costs will increase—from mortgages to car loans to credit cards, and this will trickle down with similar results on Canadian borrowing costs.
Of course, all of this will take time to materialize. But homeowners looking to renew their mortgage loan, home buyers looking to lock in rates should keep this in mind. Home sellers should also be aware: Any increase in mortgage rates will certainly dampen the housing market, possibly prompting stagnant pricing or even depreciation in home prices.