Will the Bank of Canada follow the Federal Reserve?
For any company doing cross border business, interest rate policies from both the Bank of Canada and the Federal Reserve have been one of the key factors driving the USD/CAD exchange rate, and in turn, affecting your bottom line. For the longest time it has been accepted that the Bank of Canada typically will follow the direction of the Federal Reserves’ interest rate policy, with a minor fluctuation in the spread as both countries trend in the same direction.
With Fed Chair Janet Yelen all but guaranteeing an interest rate hike later this year, should we expect the Bank of Canada to follow? Or are we in a new economic environment where new trends may differ from the past? Many analysts feel that this time around the Bank of Canada will diverge from the path of the Federal Reserve and there are a couple reasons for this.
First, the correlation of Canadian GDP to U.S. domestic demand is less than it has been in the past. Even though the pace of economic recovery is vital to the pace of Canadian growth, the two nations are not as closely linked as they once were. The share of US-bound exports in Canadian GDP reached a peak if 37.2% in 2000, whereas today the share is 22.9%. In the early 2000’s, a 1% increase in U.S. domestic demand was associated with a 0.5% boost to Canadian GDP, whereas today this correlation is a about half that, a 1% increase in U.S. domestic demand will account for an increase of about 0.25% in Canadian GDP.
Second, Canada’s economy is seen as more interest-rate sensitive than the U.S. With a larger share of interest-rate sensitive sectors in Canadian GDP, higher rates could have a much stronger dampening effect on growth resulting in weaker homebuilding activity in Canada vs the U.S. Residential investments account for 7% of GDP in Canada, whereas in the U.S. it is less than half of that. Canada also holds a much higher household debt to disposable income at 163% vs. 132% in the U.S. With diverging economic paths to consider, many analysts predict that the Bank of Canada’s monetary policy will continue with the low interest rate environment, even as the Federal Reserve tightens.
If Canadian growth falls short of the Bank of Canada’s outlook as many expect, we could see an additional rate cut later this year. Regardless of further rate cuts or not, where interests rates move going forward, and any divergence away from what is considered the norm will definitely have an impact on USD/CAD exchange rates.