After much anticipation, the U.S. Federal Reserve hiked the federal funds rate by 25 basis points (bps) signaling the start of a cautious tightening cycle after seven years of a near zero percent policy rate. What does this mean for Canada? First, it is good news for Canada that the Fed felt enough confidence in the U.S. economic recovery to start the process of interest rate normalization. The U.S. is Canada’s largest trading partner and this should give Canada some comfort that export growth will be sustainable and is likely to accelerate. Also, as the Fed begins to raise rates ahead of the Bank of Canada (BOC), the Canadian dollar should weaken relative to the greenback. A weaker exchange rate should also support export growth.
The main headwind of tighter U.S. monetary policy for the Canadian economy is higher Canadian interest rates. As interest rates in the U.S. rise across the yield curve in reaction to the higher fed funds rate, they should also push Canadian interest rates higher, as they are generally positively correlated to changes in U.S. yields. Higher Canadian rates will tighten financial conditions for consumers and companies as yields on new loans rise.
Former BOC Governor Mark Carney famously said that there are limits to which Canadian and U.S. monetary policy can diverge. In 2015, monetary policy has diverged by 75 bps as the BOC already cut rates by 50 bps this year ahead of this week’s decision by the Fed to hike rates by 25 bps. And, we believe the BOC is more likely to cut rates again rather than increase them as long as Canadian oil prices remain in the low $20-per-barrel range. Canada is still trying to navigate the negative oil price shock which makes many Canadian energy projects uneconomical at current prices. At the same time, the federal government has embarked upon another round of macro-prudential tightening of mortgage finance rules, which may dampen economic growth in consumption and residential investment.
Add this all up, and we do not see the BOC hiking rates until there is a meaningful and sustained rebound in oil prices (see below). In all likelihood, the move from the Fed this week will cause the Canadian yield curve to steepen, as front-end rates remain anchored by the dovish BOC, and rates rise across the rest of the yield curve in reaction to higher U.S. rates.