Investors are having a field day betting that the Bank of Canada will employ an interest cut later this year, taking after the Fed which is said to have an 89 percent chance of cutting rates by September. Trading in the swaps market has so far indicated a Bank of Canada match at the Oct. 30 meeting of about 50 percent chance for a rate cut. On the other hand, analysts are betting that Bank of Canada’s interest rates, currently at $1.75 percent, will go unchanged this year.
Traders are betting based on the decision of U.S. President Donald Trump to impose tariffs on Mexican products as a way to pressure the country to stop the flow of illegal immigrants from Central America. This will have a direct negative implication to the recently ratified North America Free Trade Agreement of which Canada is a member.
There is a widespread belief that the U.S. economy is on a slow down as a result of Trump’s trade wars against countries which used to be the nation’s strongest trade allies. Aside from Mexico, one example would be is U.S.’ escalating trade war with China of which the Asian country showed no sign of surrendering.
Stock traders rejoice on possible Fed rate cuts
Reacting on Trump’s move to impose additional tariffs on Mexican goods while the country still battles with China for the same reason, Chairman Jerome Powell said the Fed will protect the U.S. economy by any means necessary.
“We are closely monitoring the implications of these developments for the U.S. economic outlook and, as always, we will act as appropriate to sustain the expansion,” he said at one conference in Chicago this week. Observers were quick to point out that the best way to protect the economy is by cutting rates.
Indeed, Powell’s statement was enough to lift the stock markets this week. The Dow Jones industrial average was up over 400 points at mid-day at one point.
While there is no direct relationship between interest rates and the stock market, the general trend is that when Fed cuts interest rates, the stock market goes up; Fed raises interest rates, the stock market goes down. This is not always the case of course, but, the seeming causal effect has always something to do with how money gets in and out of the hands of the people.
When interest rates fall
Central banks cut rates in the event that economic slowdown is apparent. This is because lower interest rates make people financially confident and in effect boost their purchasing power. They have the confidence to borrow from the bank or invest their money in one way or another.
For example, with lower interest rates, people can acquire homes through financing. There will be personal borrowing. There will also be bank to bank borrowing. Whatever the process will be, there will be profits for businesses involved along the way.
Profits for businesses plus lowered interest when they decide to borrow from the bank can make businesses engage in more acquisitions or expansions at lower operational cost. This makes them attractive for investors since any form of expansions indicates earnings potential. In the end, profits from consumers and any acquisitions can boost higher stock prices for companies.
The above example is the reason why in the event of lower federal rates, utilities and real estate investment trust funds can usually pay higher dividends.
When interest rates rise
When there is an extremely high economic activity, central banks do the opposite. They increase interest rates to stop inflation and manage economic growth to a more sustainable level.
Rising rates curtail the purchasing power of the people. Consumers may feel this through, for example, increase credit card rates or higher mortgage interest rates. The idea is that rate hikes are implemented to lower down the amount of money that consumers spend.
And, if people do not spend money, businesses suffer fewer revenues and profits. Businesses would also find it hard to borrow money from the banks for their acquisitions or expansions. To some extent, companies may have cutbacks, and suffer a decrease in earnings. For public companies, these events can bring a negative impact on their stock prices.
Would the Fed increase the rate and would Bank of Canada follow suit?
With how the developments are unfolding, traders seem to have a strong basis that Canada will be seeing lower interest rates by the end of the year. This is because the Fed has no more room to increase rates and is possibly left with the only option of cutting interest rates. The Fed has already increased rates four times last year, bringing it to a total of nine times this year.
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