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U.S. Interest Rates Cascade to Canada

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Arif Harji
by Arif Harji on December 13, 2018

BLOGS

The U.S. economy with its GDP of over $18.6 trillion remains the world’s largest. It does not operate in a vacuum. 

When the U.S. economy contracts or expands it sets in motion events that have both domestic and international economic repercussions. Canada is not exempt, and in some respects, it feels the pain or enjoys the benefits as intensely as our southern trading partner.

The Federal Reserve stirs the pot

The U.S. Federal Reserve is an independent agency with the power to raise the cost of borrowing. In good times (expansions) they raise the U.S. Federal funds rate (hereinafter referred to as the interest rate) to keep inflation in check. When times are tough (contractions), they lower the interest rate to help move the economy along.

 A graphic example of the Fed’s stirring the pot occurred in 2007. As the country began sinking into a recession, the Fed lowered the interest rate from 5.25 to less than 1 percent. Low-interest rates held until 2018, when they raised the rate back to 1.75 percent with plans to move it to 2 percent by the end of the year. 

The stirring makes waves

A change in the interest rate impacts everything from household spending and investing to home mortgages and foreign exchange rates. Higher interest rates increase the greenback’s value relative to other currencies. Other factors include unemployment data, inflation rates, consumer confidence as well as the political climate. 

3 ways the waves spill over to the USD/CAD currency exchange rate

The USD/CAD exchange rate has consequences well beyond the currency because:

1. As neighbouring countries, both economies have a significant impact on the other
2. A strong U.S. dollar encourages manufacturing and labour outsourcing from the U.S. into Canada. Likewise, the U.S. also tends to import more goods from Canada when the greenback is stronger 
3. If Canada or Canadian goods are comparatively cheap, based on the currency, then 4. Americans tend to do more business, buy more products and vacation more often in Canada. 

 

My Post (4)

 

Exchange rates between U.S. and Canada go beyond trade impacts. Real estate markets are also impacted. This impact is felt in at least two ways:

1. When the US dollar is stronger, Americans tend to vacation more in Canada as well as invest in the Canadian real estate market.

2. The interest rate affects the cost of real estate loans. When rates are low, buyers can get more for their dollar. As rates rise there may be less demand for mortgages as investors postpone real estate purchases hoping for lower rates. 

Negative impacts in Canada

Canadians may face negative impacts when the U.S. interest rates increase. If U.S. wages and prices rise, Canada can expect to pay more for U.S. imported goods. Someone has to bear the cost, and it is usually the consumer.

What’s ahead in U.S. interest rates

The U.S. GDP is up, the unemployment rate is down, and there are signs that the U.S. economy has improved significantly over the last 12 months. Again, as the economy improves, the Fed raises the rate to keep the economy in check and avoid scenarios of hyperinflation.

For the U.S. market, analysts predict that the Fed is going to be more proactive and hawkish under the leadership of Jerome Powell. This is important because it signals a likely increase in rates at a faster pace.

The Fed has signaled its intent to raise rates seven times during the next 3 years (through 2020). Most analysts agree that that those increases will translate to a top rate of 3%.

Meanwhile, in Canada...

 

My Post (3)

 

The Bank of Canada, however, has elected a holding pattern. According to Chris Young reporting for Global News, Canada’s central bank has kept its key interest rate “on hold at 1.25per cent” citing a climate of “broadening, important unknowns around trade"—uncertainty about U.S. tariffs and the future of NAFTA, to name two. 

Despite what appears to be a trend in growth that is solid and broad-based—and the good news that Canada’s economy is running “near capacity” with inflation “close to target”-- Bank of Canada Governor Stephen Poloz held off on moving Canada’s interest rate. 

Analysts disagree on whether Canada will follow the U.S. in incremental interest rate increases, but the smart money is on at least one more hike before the end of 2018. 

So, Canada has elected to steer a more conservative course. While not joined at the hip with its U.S. Neighbour, Canada continues to keep close watch on what the Fed does and what Donald Trump tweets.

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