When it comes to monetary policy, Canada and the U.S. usually move in the same direction. But not this year. While the Bank of Canada contemplates another interest rate cut in the spring, the U.S. Federal Reserve Board has signalled that its key rate will start moving up, perhaps as early as June. The federal funds rate has effectively been at zero since the crash of 2008-09, so this is a big deal.
Why this unusual divergence in direction? Blame it on oil. The collapse in the price of crude is taking a heavy toll on the Canadian economy. Alberta has been especially hard-hit by lower revenue and spending cutbacks, but the ripple effect has been felt right across the country. The expected export boom, which was supposed to be fuelled by a cheap loonie, has yet to materialize, leaving our near-term economic prospects in a perilous state.
In response, the Bank of Canada shocked everyone by cutting its overnight rate by a quarter of a percentage point in January, to 0.75 per cent. It held that level at its March setting but left the door open for another cut in April or May if conditions do not improve.
In a March 12 statement before the House of Commons Finance Committee, Deputy Chief of the Bank of Canada's Canadian Economic Analysis Department Rhys Mendes stated flatly that "the sizable decline in the price of oil since June 2014 is unambiguously negative for the Canadian economy."
Meanwhile, the U.S. Federal Reserve Board dropped the word "patient" from its latest statement, setting off a wave of speculation that an interest rate hike is just around the corner. It won't happen in April, but June is a possibility and if not then certainly in the fall. The pace of rate increases will be slow but by year-end, the federal funds rate is expected to be at 0.625 per cent. It's feasible the Bank of Canada rate could be lower at that point.
What does this all mean in terms of your money? Here are some things to expect.
More loonie losses. The main force behind the decline of our dollar has been the collapse in the price of oil. However, a divergence between U.S. and Canadian interest rates will exacerbate that, driving our currency even lower. If the Bank of Canada cuts again, we could see our dollar down in the 70-72-cents (U.S.) range. The obvious way to mitigate the decline in our dollar is to invest a larger portion of your portfolio in carefully selected U.S. dollar securities.
Lower returns on Canadian GICs. Did you notice what happened after the Bank of Canada cut its rate in January? First, the major banks were unusually slow to follow the BoC lead. They held off cutting their prime rate for several days, and when they finally acted they did not match the BoC's 25-basis-point drop. Prime is currently 2.85 per cent, down only 15 basis points. However, the big banks slashed their posted rates on five-year GICs by as much as half a percent. They're now offering only 1.5 per cent on average, although you can get more at smaller financial institutions. If the BoC cuts again, GICs will yield even less.
Pressure on stock markets. Generally, when the Federal Reserve Board is in a rate-raising phase, it puts pressure on stock markets. A recent report published by HSBC found that U.S. stocks gained an average of 25 per cent in the year prior to the start of Fed rate hikes but only 5 per cent in the 12 months after the first upward move. Interest-sensitive stocks, such as utilities, are especially vulnerable.
Setback for emerging markets. A strong U.S. dollar fuelled by higher interest rates is bad news for emerging markets. The Bank for International Settlements reports that non-financial borrowers in emerging markets are carrying about $4.5-trillion in U.S. dollar debt. As the greenback rises, the local currency cost of servicing that debt increases as well. A report issued on March 20 by RBC Wealth Management concluded: "The dollar's ascent means emerging nations' economic and corporate earnings outlook could deteriorate further."
Diverging bond yields. The HSBC report found that while U.S. bond yields rise as the Fed starts to tighten, the effect is more pronounced at the shorter end of the spectrum. So, for example, yields on two-year Treasuries would increase more than on five- or seven-year issues, resulting in a flattening of the yield curve. As yields move up, bond prices will decline.
We could see the opposite effect here in Canada. Bond yields fell sharply after the BoC cut its rate in January, which pushed prices higher. The yield on the benchmark two-year Government of Canada bond dipped from around 0.85 per cent to close to 0.4 per cent almost immediately. As I write it is 0.58 per cent. Longer-term bonds also saw their yields drop, but not as sharply.
What this boils down to is that there appears to be more upside for Canadian bonds than for U.S. issues over the rest of this year.
The bottom line is that the best prospects for income investors over the next 12 months appear to be in carefully selected U.S. dividend stocks and Canadian fixed-income securities. Avoid GICs and be aware that short-term bond funds, while safe, will provide very low returns. Steer clear of emerging markets.
We're in a highly unusual period. Extra caution is the order of the day.