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With Canada's latest inflation numbers coming in hotter than most pundits expected, the prospect of the Bank of Canada raising interest rates long before the U.S. Federal Reserve follows suit has moved from likelihood to foregone conclusion. While plenty of ink has already been spilled on the "will-they-or-won't-they" question, the more pressing issue in the run-up to this divergence in rate policies is what impact it might have on Canada's markets.

"While one can debate whether an independent [rate]path is appropriate, the first question is whether it makes any difference," said George Vasic, chief economist and chief strategist at UBS Securities Canada Inc., in a research note this week.

History suggests the answer to that question is a resounding "yes" for the bond market, but it's only a qualified "yes" for the Canadian dollar. Furthermore, past rate divergences have had surprisingly little influence on the Canadian equity market.


Mr. Vasic said there have only been two historical precedents in the past two decades for the Bank of Canada raising rates while the Fed wasn't - from May, 1989, to May, 1990, and from March, 2002, to June, 2003. (Although he was quick to note that in both those cases, the Fed was actually cutting rates when the Bank of Canada began hiking.)

Predictably, in both cases, the spread between Canadian and U.S. benchmark 10-year government bond yields expanded markedly - though not to the full extent of the gap in the central banks' policy rates.

The Canadian dollar also rose against its U.S. counterpart, though in a far less consistent way. In the 2002-2003 case, the loonie jumped 18 per cent during the rate divergence; but in 1989-1990, it gained a thin 3 per cent, despite a spread of more than 300 basis points in the policy rates. (A basis point is one-hundredth of a percentage point.)

The stock market, meanwhile showed little pattern at all. The S&P/TSX composite index was down in both cases; it outperformed the S&P 500 in 2002-2003 but underperformed in 1989-1990.

The key for stocks (and to some extent, the dollar) appears to have been not the rate policy divergence at all - but, rather, the commodity market.

In 1989-1990, commodity prices slipped 4.5 per cent (based on the Bank of Canada's index of prices for Canadian commodity exports). In the 2002-2003 case, commodities surged 23 per cent.

"We expect the TSX's relative fortunes to again be determined by the global conditions shaping commodity prices and the relative health of our domestic economy," he said.