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The lack of a stock market response to the Bank of Canada's rate hike is unlikely to keep central bank boss Mark Carney up at night, one economist says.John Woods/The Canadian Press

The Bank of Canada's interest rate increase on Tuesday underlines how the Canadian economy has become an island of strength among industrialized countries. But the Canadian stock market, it was quick to remind us, is no island.

Canadian equities not only showed little enthusiasm for the Bank of Canada becoming the first Group of Seven central bank to begin raising rates after the recession and credit crisis - a vote of confidence for this country's economic recovery - but by the end of the day had become overwhelmed by broader global concerns. The S&P/TSX composite index closed down 191.02 points or 1.6 per cent at 11,571.97, as weak economic signals out of Europe and China and growing tensions in the Middle East triggered another flight from risk assets and a slump in commodity prices.

The move was illustrative of how Canadian equities have become more attuned to global developments than domestic ones - even seemingly pivotal events such as the start of a Bank of Canada rate-hiking cycle.

"What matters is not so much what's going on with the economy in Canada as with economic activity in the United States and emerging markets," said Stewart Hall, economist and market strategist at HSBC Securities Canada Inc. "For stocks, there are a lot more issues going on that trump anything the Bank of Canada is doing."



The source of this ambivalence probably lies in the makeup of the Toronto Stock Exchange, which is much more exposed to natural resources and exports than is the broader Canadian economy. For example, the energy sector makes up more than one-quarter of the S&P/TSX composite, yet it represents only 6 per cent of Canadian gross domestic product.

"The structure of the overall market is more geared toward what happens with our trading partners," said Stéfane Marion, chief economist and chief strategist at National Bank Financial in Montreal.

At the same time, he said, some of the sectors that are most directly affected by interest rate movements - in particular, the consumer sectors, which are major players in the U.S. equity market - are "ridiculously small" on the TSX.

"There are some sectors that will react [to Bank of Canada rate movements] but they aren't big enough to outweigh the resource sectors."



An Investor's Guide to Understanding the Economy by Gary Rabbior:

  • Part 1: How the money in the economy is managed
  • Part 2: How inflation works
  • Part 3: Avoiding the deflationary spiral
  • Part 4: How much money is too much money?
  • Part 5: How markets and currencies work
  • Part 6: How interest rates affect your investments


Strategists and economists also noted that while the Bank of Canada rate movements had a bigger immediate impact on the Canadian stock market a decade or two ago, the central bank's own changes have served to mute the market response now. The bank's institution of inflation-rate targeting in the early 1990s, its establishment of a calendar of fixed rate-setting dates in 2000 and its efforts to improve transparency in communicating its policy considerations have all made rate decisions more predictable.

"What matters really [for the stock market's immediate response to rate changes]is the element of surprise," said Avery Shenfeld, chief economist and chief strategist at CIBC World Markets. "For the most part, the Bank of Canada has done a pretty good job of signalling what it's going to do."

Experts also noted that, unlike the bond and currency markets, the impact of a central bank rate change on equities is far less clear cut.

"In general, equities have a very mixed relationship with central banks," said Eric Lascelles, chief economics and rates strategist at TD Securities. On the one hand, higher rates tend to dampen stock valuations, because they offer improved returns for a competing class of investment assets (namely, bonds). But on the other hand, he said, they're often confirmation of accelerating economic prospects, which are good for profit growth.

Mr. Shenfeld noted that beyond the immediate stock market reaction, the start of a Bank of Canada rate-hiking cycle has generally been good news for Canadian stocks. A recent study by CIBC World Markets found that, on average, the S&P/TSX composite has generated annualized returns of 8.3 per cent in the six months after rates hit their bottom and turned upward - well ahead of the 5.5-per-cent average returns in the bond market.

Mr. Marion argued that the lack of a stock market response to the Bank of Canada rate hike shouldn't keep the central bank's boss up at night, anyway.

"I don't think Mark Carney will be frustrated by that," he said. "I think he'd be much more frustrated if he had no impact on the [bond]yield curve. Because that's really the Bank of Canada's job."

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