The Fed's Effect On Canadian Stocks

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Ingram Publishing / Thinkstock

Ingram Publishing / Thinkstock

In recent weeks, market participants have once again begun handicapping the odds that the Federal Reserve (Fed) will hike interest rates for a second time this summer. The debate and anxiety over whether the Fed will move in June, July or September misses a larger point: The Fed will likely move interest rates slowly and deliberately higher and will have its eyes focused squarely on the global economy and financial market conditions as it normalizes monetary policy. We don't think the Fed is any hurry to raise rates and should continue to keep its options wide open.

There is, however, a tendency to worry that the Fed's efforts to raise interest rates will somehow complicate the outlook for riskier assets like stocks. Perhaps the thinking goes that since monetary accommodation was helpful for inflating asset prices and suppressing volatility that the reverse will prove problematic. While we wouldn't rule out the prospects for further stock market gains, global equity returns are likely to be more modest and volatility more elevated from here, especially because stock markets are more fully valued these days.

But what about the effect on Canadian stocks? Could the Fed's rate increases spell trouble for Canadian equity investors and what could it do to the Canadian dollar? I took a look at the historical precedent to get a sense of what the early stages of Fed rate hikes mean for Canadian investors. While there is admittedly a limited sample size of only four comparable episodes in 1994, 1999, 2004 and today's, the data is modestly encouraging.

For starters, the Fed's current rate normalization campaign is incredibly modest by historical standards (see the chart below). While it's far easier for short-term interest rates to double given their low level today, the pace of rate hikes since December has been and is likely to be far more modest than at any time in the past 25 years.

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Second, despite all the predictions for a stronger U.S. dollar as the Fed raises rates, the historical experience has been rather the opposite from the standpoint of a Canadian investor (see the chart below). In the four episodes dating back to 1994, the Loonie has held up rather well heading into the Fed's first rate increase. In other words, if the past is any guide, we can't expect the Loonie to suffer just because the Fed is raising rates and the Bank of Canada is holding rates steady. If oil prices continue to firm as the Fed pushes rates higher (a reasonable assumption), then any downward pressure on the Loonie from higher short-term U.S. interest rates could be partially or fully offset by the move higher in oil prices.

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Third, Canadian stocks have historically held up well in both absolute terms and relative to the U.S. when the Fed is raising interest rates. With the exception of 1994 when the Fed doubled short-term interest rates from 3% to 6% in the span of a year, Canadian stocks have outperformed U.S. stocks (substantially so in two instances) during periods of Fed rate normalization (see the chart below). In each of these four periods, Canadian equities were either flat or higher during the 12 months after the Fed began its tightening cycle.

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Given the potential for a slow and deliberate reversal of short-term interest rates in the U.S., we think global equities will deliver more muted returns against a backdrop of higher volatility. We think the Fed is poised to raise rates once this summer. However, to the extent that the Fed raises rates as it sees confirmation of a steady reflation of the economy and either stable or higher commodity prices, this can favor Canadian equity markets and is unlikely to put undue downward pressure on the Canadian dollar.

Source: BlackRock Investment Institute and Bloomberg.

This post originally appeared on the BlackRock Blog.