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Will Canada Follow the Fed’s Interest Rate Cut Lead?

Jon Brown Jon Brown, Stockhouse
0 Comments| August 6, 2019


As the summer of 2019 begins to wind down, investors are preparing for what could be an exciting end to what is usually a quiet time for global markets.

Canadian investors had been running on hopes of a rebounding Canadian economy, though the story that is being digested appears to contradict that narrative. Retailers reported a surprise decline in sales, according to a recent report from Statistics Canada. The agency noted that sales declined 0.1% in May, though economists had expected an increase of 0.3%. The drop was even greater when excluding motor vehicle and gasoline sales, at 1%.


This comes as many believe the Bank of Canada could follow the US Federal Reserve, who is likely considered to do something it hasn’t done in over a decade – cut its benchmark interest rate.

The idea south of the border is that by lowering its key short-term rate, borrowing and spending is encouraged, thus energizing the economy while affecting consumer and business loans. Would this work in Canada? StatsCan’s data highlights the high level of debt service costs, which now sit close to its highest point since the 2008 financial crisis. The first thing to be compromised is disposable income, meaning consumers would be less likely to contribute to economic growth.

 
By the numbers:

  • The general merchandise sector lost 1.1%
  • Clothing sales decreased 2.7%
  • Beer, wine and liquor store sales were also down 2.7%
  • Food sales fell 2%
  • Housing market prices are also shrinking, as eastern Canada is in recovery mode while western Canada’s prices have remained firm
  • Eight provinces saw sales trend downward.

An interesting aside: One subsector that did see substantial growth is cannabis. Retail sales grew 14.8% that month, the third straight month of double-digit increases, surpassing $85 million. These gains were widespread across all provinces, led by Québec and Ontario.

 
Low US rates’ impact on Canada

Click to enlarge

In what could be a move to combat the possible fallout from the ongoing Washington / Beijing trade war, the possible rate cut would have a ripple effect on Canada’s economy.

Mortgage brokers have been calling this a strange turn of events, where fixed rates have become lower than variable rates. Usually people would find themselves paying a premium for the peace of mind to know that their rates won’t change, and it was a big selling factor. Because of what is happening with the bond market, there has been a shift.

For months, investors, especially in the US, have been worried about an economic slowdown, this created an expectation that interest rates would be lower in the future, which sent interest rates on longer-term bonds below the interest on short-term debt. This move had an effect on the mortgage market where five-year fixed-rate mortgages tend to follow long-term bonds, variable rates move with short-term interest rates. The central bank sets the benchmark rate.

Expectations of an interest rate cut by the US Federal Reserve have now brought things back to normal by bringing short-term rates below long-term rates. In Canada, the economy is relatively stable, and the Bank of Canada hasn’t indicated in any solid fashion that it will cut rates. For the next while, fixed rate mortgages in Canada will likely remain cheaper than those with a variable rate.

For example, according to Ratehub.ca, 2.84% is the lowest variable-rate Canadians can get on a typical five-year mortgage, but the lowest fixed-rate is 2.69%. On a %400,000 mortgage, the difference is around $2,800 on interest savings over five years.

 
What’s next?

August is typically a quiet month among markets, we could see a summer rally in the coming weeks. After weeks of “Will they, or won’t they?” among investors, expectations for a quarter-percentage-point rate cut stood just below 80% as of Friday July 27th, while the remaining 20% predicts a half-point cut. For more than a month, the S&P 500 and Dow Jones have rallied 10.1% and 9.4% and along with the Nasdaq have broken records after Fed Chair Jerome Powell said the central bank would “Act as appropriate” to keep this expansion of the economy going. Since lower interest rates would mean easier borrowing for companies, this rally could continue. There are also deeper implications into Bank of Canada's trade concerns and more.

 
Higher and higher?

Wall Street markets have been seeing rally since May and has been hitting new highs in July 2019. The good news is expected to continue, given the potential jolt stocks would likely receive if the Federal Reserve cut interest rates this week.

Economists have forecast one to three rate cuts this year, after raising rates four times last year as a response to continued growth in the economy. The July US jobs report is also looming, which would be an early indicator if the Fed made the right move. A cut of a quarter point to bolster the level of capital that is flowing through markets could support people’s ability to borrow more money. If the US central bank acts as predicted, it would put more pressure on Canada’s central bank to follow suit. Both economies are looking at this move as an answer to their trade concerns.

 
The other side:

This could all be conjecture and even StatsCan pointed out that despite a drop, retail sales grew in Toronto, Montreal and Vancouver, the most populated Canadian cities. There is also its “trading day adjustment” to take into consideration, where May’s results could have looked worse off given the lack of heavier shopping days in the month compared to others. There is also the fact that Ontario and Québec saw record rainfall that month, which could have kept many people indoors.

Some experts are skeptical that the rate cuts by the Fed will do what is expected to liven up the economy when borrowing rates in the US are already quite low. Some who monitor the industry are concerned that this is an unnecessary risk by the central bank, since cutting rates now means the Fed is disarming itself from some ammo in its arsenal in case the economy did end up falling into another recession. Some feel that by pushing rates even lower, the Fed could be blowing the bubble even bigger.

The economy seems stable and trade negotiations with China appear to be back on track, whatever ramifications that come from lowering rates remains to be seen, but many investors may regret fighting the hand that Fed them.



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