It’s becoming increasingly likely that at the end of July 2019, the Federal Reserve will cut its overnight rate from 2.25% to 2%, the first decline in 11 years. With the U.S. economy seemingly slowing down and with a trade war threatening to derail what’s been fairly good growth, Fed chairman Jerome Powell has indicated that easing may be on its way. “Many FOMC participants judged at the time of our most recent meeting in June that the combination of [trade and slowing global growth] strengthens the case for a somewhat more accommodative stance of policy,” he said at a speech in Paris on June 16.
On this side of the border, the outlook is decidedly different. After a weak Q4 and Q1, Canada’s economy is gaining steam, with about 250,000 jobs added since January. On July 10, Stephen Poloz, the Bank of Canada’s governor, said rate cuts are not in Canada’s future, despite continued concerns over trade. “Recent data show the Canadian economy is returning to potential growth. However, the outlook is clouded by persistent trade tensions,” he said in a statement, after holding Canada’s overnight rate at 1.75%. “Taken together, the degree of accommodation being provided by the current policy rate remains appropriate.”
Some people may be surprised to hear that the BoC plans on doing things differently than the Federal Reserve—there’s a misconception that it always follows the Fed—but that’s exactly what is about to happen. While it may be a little much to say that the two central banks are diverging on monetary policy, the fact that they have their own ideas as to where rates should go could have an impact on Canadian investors. Here’s how.
Rising Canadian dollar could boost energy, hurt manufacturing
We’re already seeing some of the effects of a rate cut, even before it’s happened. Since January, when Powell started taking a more dovish tone to U.S. monetary policy, the loonie has risen by about 4.7%. It hit a nine-month high against the greenback in July, and a number of financial strategists think the Canadian dollar could reach 80 cents U.S., about three cents higher than in mid-July.
Part of the reason for the gain is that currency investors tend to be attracted to stronger economies—and people have more confidence in Canada than America right now. While foreign exchange fluctuations are hard to predict and shouldn’t be the only reason to invest in one thing over another, a strengthening dollar will help boost commodity prices, which is a boon for Canada’s energy sector. That’s because commodities are priced in USD and so when the dollar falls, demand for oil and gas grows as these goods become cheaper for foreign companies and countries to buy.
At the same time, the manufacturing sector may suffer since it now becomes more expensive for Americans to buy Canadian goods. That could present some problems, says Brendan LaCerda, a senior economist with Moody’s Analytics. “This might worry the BoC,” he says. “If the Fed cutting rates causes the Canadian dollar to appreciate, then that could hurt the competitiveness of Canadian exports, which would hurt GDP growth.”
Investors will start hunting for yield—again
The last time the Federal Reserve cut rates, investors went on a mad search for higher-yielding investments. Something like that could happen again, says Kristina Hooper, Invesco’s Global Chief Economist. If U.S. rates fall and fixed income yields end up higher here—the yield on the 10-year U.S. Treasury bond is currently at around 2%, while Canada’s 10-year bond is yielding 1.6%—people could start buying more Canadian government bonds. “You’ll likely see flows increase into Canada because yields would be more attractive if we see U.S. yields along the curve go lower,” she says.
If that happens, bond prices on Canadian fixed income could rise, though yields would then fall. People could also start scooping up companies in higher-yielding sectors, such as utilities and REITs—and both industries have done well since January. The S&P/TSX Capped Utilities Index is up more than 20% this year, while the S&P/TSX Capped REIT Index has risen by more than 12%. (The S&P/TSX Composite Index is up about 15% year-to-date.) “Financial repression drives investors to yield and it’s not just yield on the fixed income side,” she says. “If growth is improving, then an area to focus on would be dividend-paying stocks.”
Equities will climb higher
Want to know why the S&P 500 is up almost 20% this year, even though President Donald Trump continues to threaten global growth with a never-ending trade war? Because of the potential for lower rates. Usually, when rates fall, stocks climb as it becomes easier for companies to borrow money—funds they can use to invest in growth. It also gets cheaper for businesses to service their debts, which can help expand earnings. Even though Canada’s standing pat, our market will still benefit from more bullish equity market sentiment overall. “It’s positive for all stocks, not just U.S.,” says Hooper. “It has a spillover effect on equities elsewhere.”
Hooper also suggests taking a look at Canadian energy companies, and to pay attention to financial stocks, as well. Typically, financial companies, such as banks and insurers, see share prices increase when rates rise. Having the U.S. slash its rate while Canada stays put would have a similar effect, she says. Some technology names could benefit as well. “A rate cut usually benefits areas of the stock market where valuations are more stretched, like technology,” she says.
However, the good times could be short-lived. Earnings are expected to expand more slowly over the next few quarters, thanks to trade and slowing global growth, she says.
Canadian investors will ultimately benefit from a U.S. rate cut even if the BoC doesn’t budge on its own rate. LaCerda doesn’t think they’ll do anything for a while but, then again, you never know. “We don’t expect any change in Canadian monetary policy until late 2020, when they’ll hike rates again,” he says. “But the BoC has said it’s worried about household spending, oil prices and global trade, and if we do see a deterioration in these we would expect a rate cut.”