Canada is the second G7 country to embark on the path of normalizing monetary policy. Raising the key interest rate to 0.75 per cent, the Bank of Canada also adopted a bias towards tightening policy over time and reversing the “insurance” rate cuts of 2015. The move bolstered the Canadian dollar, trading at highs not seen in more than a year against the U.S. dollar.
Economically it’s probably a good time for Canada to raise rates. The rate increase is being viewed as a sign of confidence in the Canadian economy and the TSX jumped after the open on Wednesday. Energy stocks, bolstered by higher oil prices, and materials led the rally.
If you read between the lines, the hike is a signal to the market that the central bank wants the Canadian housing and mortgage game to get serious, and this is the first volley.
What’s At Stake for Exporters?
For small and medium sized Canadian exporters, this translates into more purchasing power, but it can also hurt accounts receivables.
As the Canadian dollar appreciates, it makes Canadian goods and services more expensive in comparison to global competitors. It also has the effect of reducing the value of Canadian owned corporate profits from global operations. This makes for a more challenging environment for Canadian companies and may ultimately end up negatively affecting their profit margins.
Foreign exchange is the largest and most liquid market in the world. Currencies are constantly fluctuating, and currency risk is a key consideration that is often overlooked.
READ MORE: Why the Bank of Canada hiked interest rates
A stronger dollar may well impact a number of large Canadian corporations that compete in global markets.
Canada’s oil producers are a prime example of how this exposure can affect exporters. Oil prices are denominated in U.S. dollars, so producers must sell their product in that currency, but pay their local expenses in Canadian dollars. A producer moving funds back before the hike would have been earning around $1.29 for each U.S. dollar. Fast-forward to the post-rate rise spike in the loonie and that same producer is now getting $1.27 per U.S. dollar—two full cents less in a matter of minutes.
While the Bank’s hawkish tilt should continue to support the Canadian dollar in the short term, the outlook remains highly uncertain for the currency and the subsequent impact on Canadian exporters.
Investors were especially surprised by the extent to which the central bank downplayed weak inflation. Inflation has been moving away from the bank’s two percent target for months, yet this did not seem to dissuade policymakers. The monetary policy report stated that inflation may weaken further in the coming months before reaching their target sometime next year. Downside pressure is viewed as a result of so-called temporary factors such as cheap energy prices for consumers. By discounting this weakness, the bank is allowing investors to look past subpar data in the near-term. Bank of Canada Governor Stephen Poloz likened a reactionary approach to the latest inflation figures to “driving while looking in the rear-view mirror.”
Economic growth in Canada is among the best of any major economy. Yet even a slowdown in growth would not deter the Bank of Canada. The Bank expects the first quarter’s strong 3.5 percent growth rate to moderate over the rest of the year, but stay above potential economic growth. This should support a stronger currency which could continue to weigh on receivables from abroad.
Investors are now pricing in another rate hike before year-end, but as Poloz emphasized, policy is not a predetermined path. The future path of monetary policy will “remain highly data-dependent,” he said, driving home the bank’s message: “The Bank will continue to analyze short-term inflation fluctuations to determine the extent to which it remains appropriate to look through them.”
READ MORE: Interest rate hike: Why Stephen Poloz still sounds anxious
Being data dependent will allow them to adapt to changes in the landscape of the economy, but it also introduces a set of inherent unknowns. Leaving policy prescriptions open-ended exposes a high degree of uncertainty for financial markets, especially currencies. Investors will price in the predicable, promoting smoother more measured moves in the market. New developments that take us by surprise cause knee-jerk reactions and rapid corrections as traders revise their views, sparking volatility that has a direct effect on prices for businesses working cross-border.
If the economy picks up as the Bank of Canada predicts, we would look to see a stronger Canadian dollar over the next year, but the unknowns inject fresh uncertainty into the outlook for the loonie.
The Trump administration’s capricious approach to trade policy adds another layer of concern. The Bank of Canada will need to keep a watchful eye on these developments so that we can react quickly to any adverse developments in the U.S. market. Keeping this in our sights will help ensure that Canadian businesses remain globally competitive.
Omar Allam is founder & CEO of the Allam Advisory Group, a global trade consulting firm. Natalie Ciavarella is head of currency strategy responsible for North America with World First, a Fintech company that provides global currency services to businesses and individuals worldwide.