Bank of Canada Raises Interest Rates

The Bank of Canada (“BOC”) increased interest rates on the back of recently released economic data showing that growth was higher than expected, thereby supporting the bank’s view that growth in the country is becoming more broadly based and self-sustaining. To buttress the Bank of Canada’s view, the bank reported that consumer spending remain robust, underpinned by continued solid employment and income growth and great GDP numbers. This gave the BOC reason to review the MPR and ultimately decide to increase it in a bid to stabilize the economy and possibly eliminate the threat of inflation. This post seeks to analyze the implication of the interest rate hike to the economy.

The BOC is tightening its monetary policy, and with respect to interest rates, the tightening began in July 2017 when the Bank of Canada raised rates from 0.5 percent to 0.75 percent on the 6^th of September, it was again increased by 0.25 percent to arrive at an MPR of 1.0. At the current rate of 1.0 percent, the MPR is back to pre-oil crisis rate with the rates being cut from 1.0 percent to 0.75 percent in January 2015 and from 0.75 to 0.50 percent in July 2015. Rates were cut back then in 2015 to act as a stimulus for economic growth during dwindling oil prices (Oil makes up about 40 percent of Canada’s export). Economists and investors are concerned that the aggressive increase in interest rates may prove too much for the economy to handle because in barely three months, interest rates doubled from 0.5 percent to 1.0 percent.

Following from the rate hike, the Canadian dollar touched a 2 year high, reason being that with the rise in interest rates, lenders are offered better rates of return compared to other jurisdictions. This attracts increased rates of return then attracts foreign capital, thereby increasing the demand of the currency in the international foreign exchange market. To the strengthening Canadian dollar, the upside is that the country is able to attract foreign capital for development of the economy. The downside however is in terms of exports as Canadian exports become more expensive compared to other products. This thereby reduces the demand for Canadian exports.

I think with the hike in interest rate, the BOC would be watching the markets closely to see if we would continue to see earnings growth in the next couple of quarters, and if it would be sustainable into the future. To determine the effect of the interest rate hike, we would be focusing more on revenue growth driving earnings growth as opposed to cost optimization strategies which may be adopted by various companies.

For bonds, new issues should have a higher coupon rate, while existing bonds would see increased yields as the market price for the bonds fall considering it was issued at a fixed coupon rate when the MPR was normal. When it comes to mortgages, consumers with floating rate mortgages will feel the brunt of the overnight increase in MPR as financial institutions have already started pushing up their lending rates.