Canada’s Rate Cut and What It Means for US Investors

Yesterday the Bank of Canada lowered its target overnight rate .5% to 3.5%, this was its steepest cut since 2001 and comes a little more than a month after the bank lowered that same rate to 4.0% from 4.25%. Canada has felt the need to lower its target overnight rate on multiple occasions this year because of the precipitous decline in the US economy, which is the recipient of roughly 80% of Canadian exports. The document released yesterday by the Bank of Canada cites progressive weakness in the United States housing market, abatement in inflation risk, and strong annualized GDP as the basis for the rate cut decision. The most notable commentary by the bank came in regards to its forecast for future rate cut decisions, “further monetary stimulus is likely to be required in the near term”, which almost explicitly paves the way for future rate cuts at the banks next meeting on April 22. The real value of these statements from the BOC doesn't come from what we can expect Canada to do in the near future but rather what this means for central banks around the world, especially in Europe.

Now although Europe only exports 13% of its goods to the US, the secondary effects of the US economy on Europe’s larger direct trading partners are soon to be felt. Much of Europe’s hopes for continued economic expansion without decreased lending rates rely heavily on the idea that emerging market demand will compensate for the slowdown in exports to the US. However Asia (excluding Japan), Russia and Latin America, which account for 26% of European exports, are already beginning to feel the effects of their reliance on American consumer spending, which still accounts for nearly 20% of worldwide GDP. The decline in exports from these countries to the US will affect Europe as these same corporations engage in fewer capital expenditures in attempts to cut costs and salvage their bottom lines. These connections may have not yet surfaced in the Eurozone but it does not seem as though they could be too far out.

A European rate cuts should have a couple key effects for American investors:

- By decreasing interest rates the ECB will effectively decrease the demand for the European currency which should directly improve the prospects of the dollar by not only indirectly increasing its relative appeal but also by providing investors less incentive to barrow the dollar as a carry trade currency in order to fund the purchase of the Euro (more on this in a future post).

- An increase in the value of the dollar will in turn alleviate some of the fire which is helping to fuel the rise in commodity prices as these dollar denominated assets have become progressively less expensive for non US investors due to favorable exchange rates steaming from the dollar's decline.

- If this course of events does take place and the dollar continues to appreciate against the Euro I expect to see a noticeable decline in earnings momentum from US companies (such as Intel and McDonalds) whose international exposure has helped their numbers significantly through the course of the dollars fall.

Now days we often hear talk of United States decoupling from the emerging markets and while that may have its merits, United States decoupling from Europe could prove to be a very different story.


Andrew