The Canadian Market Rallied on Higher U.S. Rates

Investors hate uncertainty. The proof is the apparent relief with which the market rallied on Wednesday after the U.S. Federal Reserve finally consummated its year-long flirtation with moving off the zero bound.

The Fed may have raised the cost of money, but that was already priced into the market. Instead, stocks were soothed by the Fed’s largely dovish tone, including the reiteration that tightening would be gradual.

Central bank chief Janet Yellen tried to keep all options open for the future direction of monetary policy, acknowledging that global headwinds, both known and unknown, could force the Fed to move more slowly or even revert to easing.

However, the so-called dot plot, which depicts the anonymous predictions of members of the central bank’s Federal Open Market Committee, shows that most expect the federal funds rate will be at 1.375% by the end of 2016, suggesting that more rate hikes are on the way.

This dovetails with the Fed’s cautious optimism about the pace of U.S. economic growth, as well as progress toward achieving its twin mandates of targeting inflation at 2% and spurring full employment. And the market appreciated this relatively sunny outlook, since another deferral would have implied the central bank was seeing cracks in the economy.

Even the Canadian benchmark S&P/TSX Composite Index rose in afternoon trading, ending Wednesday’s market session 1.9% higher.

Why would the Canadian stock market rally in response to the U.S. central bank’s action? There are two main reasons.

The most obvious is that a rate rise signals that U.S. growth is headed in the right direction. The U.S. is a top destination for Canadian goods, absorbing about three-quarters of its neighbor’s exports. So a growing U.S. economy augurs well for growing U.S. demand for Canadian goods.

The other reason is also tied to cross-border trade: A falling exchange rate makes Canadian goods more affordable and, therefore, more competitive in the U.S. market.

Following the Fed’s latest move, the Canadian dollar now trades just below US$0.72, its lowest level in 11 years.

And the loonie looks likely to hit US$0.70 in the months ahead, especially if the Fed continues raising rates. That level would provide a very attractive entry point for long-term U.S. investors.

In fact, foreign investors are starting to see value in Canadian stocks again. After significant summer outflows, foreign investors poured C$6.7 billion into Canadian equities in September and October. Inflows during those two months accounted for more than three-quarters of the year-to-date total, according to Statistics Canada.

Although historically the Bank of Canada (BoC) has followed the Fed’s cues, the two central banks don’t always march in lockstep. And their current divergence in policymaking is a big part of the loonie’s slide back below parity with the U.S. dollar over the past few years—the other part, of course, is the economic shock resulting from the crash in crude oil prices.

At first glance, it might seem odd that the Canadian dollar should already be discounted so heavily against the greenback. After all, even after two rate cuts, Canada’s benchmark overnight rate is at 0.50%, with the effective rate likely being somewhat higher than the midpoint of the federal funds rate’s new targeted range of 0.25% to 0.50%.

But it’s the overall trajectory of monetary policy that matters. And right now, a majority of traders are betting that the federal funds rate will be at least 0.75% by the end of 2016. By contrast, the market expects at least one more rate cut from the BoC by December of next year. That should keep pressure on the loonie.

Export-oriented industries will benefit from a lower exchange rate, especially when U.S. dollar-denominated sales are translated back into loonies. And that’s why Canadian investors were smiling yesterday.

During last week’s Live Web Chat for Canadian Edge subscribers, Chief Investment Strategist Deon Vernooy detailed his top investment themes for 2016. If you missed it, you can still read the transcript.

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