5 Consequences for Canadians of the Bank of Canada's Rate Decision

January 26th, 2015

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This blog post was originally published on the blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

Last Wednesday, the Bank of Canada (BoC) made a surprise move and cut the benchmark interest rate from 1% per year to 0.75% per year. The BoC is the government entity tasked with setting short term interest rates in Canada.

This move by the BoC will affect Canadians in a number of ways, especially for those of us who invest in stocks and bonds. In this article, Ill explain 5 such consequences that we as Canadian investors can expect.

Why the Bank Of Canada Lowered Rates

First, let me explain why the BoC would want to move interest rates down. Lower interest rates affect the behaviour of Canadians in two major ways.

For Canadians that want to borrow money, it means lower borrowing costs, which encourages Canadians to borrow. For example, you would be more tempted to get a mortgage when interest rates are lower.

More borrowing results in more spending, which stimulates the economy. This happens because spending always increases someone elses income. For example, when you buy food at the grocery store, a portion of the money you spent becomes wages for the cashier. Other portions of your spent money go towards paying farmers, truckers, etc.

On the other hand, for Canadians who want to save money, lower interest rates means lower interest income. With lower interest rates, money in your savings account will not grow as quickly.

Since saving money becomes less rewarding with lower interest rates, savers might be tempted to spend the money instead. This spending also serves to stimulate the economy.

In summary, lower interest rates serve to stimulate the economy by encouraging borrowing and discouraging saving. By lowering interest rates, the BoC is signalling that the Canadian economy needs to be stimulated. In their opinion, the recent crash in oil prices will have a significantly negative impact on the Canadian economy, and thats why theyve made the decision to cut.

5 Major Consequences of Lower Rates

Now that we understand why the BoC made its decision, lets examine a number of ways the decision affects us as Canadian investors.

  1. Immediately after the BoC announced its decision, bond prices surged. For exampe, the price of XBB.TO (an ETF that invests in bonds) jumped up by 0.6% on the news, which is a big move for bonds. As our free book explains, interest rates and bonds move in opposite directions. This also means that owning bonds will generate less interest income going forward.

  2. When the BoC announced its decision, the value of the Canadian dollar went down by 1.8% relative to the U.S. dollar, which is a large drop for a currency. Let me explain why this has happened.

If youre a bond investor, it goes without saying that youd prefer to receive higher interest on your bonds. Therefore, when different countries have different interest rates on their bonds, investors gravitate towards those countries whose bonds offer higher interest rates.

With the BoCs announcement, interest rates on Canadian bonds became a lot lower compared to interest rates on U.S. bonds. As a result, investors no longer wanted to hold Canadian bonds and wanted to hold U.S. bonds instead. Investors sold Canadian bonds, exchanged their Canadian dollars for U.S. dollars, and bought U.S. bonds. This increase in demand for U.S. dollars led to the crash in the value of Canadian dollars.

  1. The rate cut by the BoC will likely help Canadian stocks go up in value. There are two major reasons for this.

One reason is that the lower exchange rates are good for Canadian companies, especially for those companies that produce in Canada but export abroad. For companies that export, their costs are tied to Canadian dollars (e.g. salaries, rent, etc.), but their sales are tied to other currencies. As other currencies, such as the U.S. dollar, go up relative to the Canadian dollar, these companies generate higher sales compared to their costs. This effect boosts profit and makes Canadian stocks more attractive from a business perspective.

The other reason lower interest rates are good for Canadian companies is because they make stocks more attractive compared to bonds. For instance, the 10-year Canadian government bond now yields less than 1.5% per year. Even if investors expect stocks to return just 4% per year, investing in stocks would look a lot more attractive than investing in bonds. This will encourage many bond investors to sell their bonds and invest in stocks instead, which will likely help Canadian stocks go up.

  1. Lower interest rates will likely keep Canadian housing prices overvalued. Canada has experienced low interest rates for some years now, which encouraged consumers to take out mortgages. This led many international observers such as the IMF to believe that Canadian housing prices are overvalued.

Note that the BoC doesnt directly control mortgage rates; lenders such as banks and credit unions do. But the lenders usually take the interest rate set by BoC into account. So while theres no guarantee that mortgage rates will fall, theres a big chance they will. Lower mortgage rates will encourage Canadians to take out more mortgages to buy houses, and that may keep Canadian housing prices high in the future.

  1. Theres a big chance that the actions of the BoC today will lead to higher inflation in the future. There are two reasons for this.

First, as we mentioned, lower interest rates will encourage Canadians to borrow more money, which will stimulate the economy. As the economy grows, inflation usually goes up as well.

Second, because the U.S. dollar is now more expensive compared to the Canadian dollar, costs of imports will rise. For example, Canadian grocery stores tend to buy a lot of fruits and vegetables from the U.S. As the cost of those fruits and vegetables rise, grocery stores may hike up their prices and you may end up with higher grocery bills than before.

An Investors Point of View

So far, we examined some of the ways in which the actions of the BoC will likely affect Canadians. Lets now look at how this may affect the way we invest going forward.

Perhaps the major impact is that bonds look even less attractive today than they did before. The higher probability of inflation, coupled with lower interest rates, mean that theres a really good chance that investors will lose money from buying bonds after taking inflation into account.

Today, as noted, the 10-year Canadian government bond yields less than 1.5% per year. This means that if inflation persists at 1.5% per year or higher for the next 10 years, then holders of 10-year government of Canada bonds will lose money after taking inflation into account. Note that Canadas inflation has averaged around 2% for the past few years.

On the other hand, some Canadian stocks look more interesting. Favourable exchange rates will help exporters such as oil and gas companies increase their profit margins. This is something Ill think about as I update MoneyGeeks model portfolios going forward.

This blog post was originally published on the blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

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