Beware falling interest rates. They’re evidence of how desperately most countries want to goose their underperforming economies and mark down their currencies.
Since the oil price crash last year, roughly two dozen central banks around the world have eased back on their monetary policy levers. Canada became an unexpected member of the rate-cutting party in January when Bank of Canada Governor Stephen Poloz surprised markets with a rate cut he had not previously signaled in any way. With the shock decision, he trashed the bank’s supposed commitment to telegraphing its thinking to markets well ahead of actual policy moves. No one should be shocked if he surprises us again.
Poloz, like other central bankers, shies away from saying he’s cutting rates to help drive down his national currency. That’s considered bad form. Instead, he prefers to focus on the other channels through which lower rates can boost demand—by reducing borrowing costs, for instance, or raising asset prices. But when all is said and done, nearly everyone agrees Poloz craves a lower loonie. A cheaper currency can stimulate manufacturing exports, and Canada badly needs a factory rebound to buffer the impact of the collapse in oil prices.
But how low will the loonie will go? And how much impact will it have? Here are three thoughts that exporters should keep in mind.
Other countries are doing the same thing. There’s no disputing that the loonie’s deep drop from parity with the U.S. dollar in early 2013 to US80¢ territory now makes Canadian factories far more competitive. However, a cheap loonie is unlikely, by itself, to generate a manufacturing renaissance given the simultaneous declines of most other major currencies against the greenback.
The euro, for instance, has also plummeted against the U.S. dollar. Extremely low—even negative—interest rates in many European countries suggest the euro may have even further to fall (see adjacent chart of central bank rate trends).
In terms of the loonie, the euro now stands roughly where it did five years ago. Canadian factories were unable to make much headway against European rivals back then and they appear no better equipped now to make inroads in continental markets.
Here in North America, Mexico is likely to also offer stiff competition for Canadian factories. Automakers have poured most of their new investment dollars into either the southern U.S. or Mexico in recent years, and recent exchange rate moves give them little reason to rethink that policy. The loonie has become only slightly more competitive against the Mexican peso over the past year and is not that much changed from where it stood five years ago. If the U.S. economy does stage a strong recovery over the next year, as many expect, Canada will face vigorous competition for a piece of that growth.
This may be only the start. Commentators used to regard low interest rates as just a passing phenomenon. They assumed rates would bounce back to much higher levels as the global recovery completed its healing from the financial crisis.
That no longer seems such a sure thing. A telling indicator of market sentiment is the benchmark 30-year Government of Canada bond. Today it pays a miserly return of roughly 2% a year to those willing to lock up their money for a generation. People buying those bonds are betting that interest rates will remain low for a long, long time.
What’s behind the rock-bottom rates? One possibility is that developed nations have slipped into a semi-permanent funk—“secular stagnation” as economists call it. Growth rates may now be entering a sustained period of slowdown because of—take your pick—aging demographics, the shift to less capital-intensive businesses, a lull in innovation, or perhaps something else entirely.
If the pessimists are right, Canada’s interest rates could have further to fall. When people are willing to buy 10-year German bonds in return for a mere 0.15% annual payoff, and investors are actually paying for the pleasure of lending money to Switzerland for a decade, Canada’s 10-year bond yield of 1.37% begins to look exceedingly generous.
A further fall in Canadian bond yields would be accompanied by yet more declines in the loonie versus the greenback. Royal Bank of Canada sees the loonie bottoming out at around US75¢, while Macquarie Group says the Canadian currency will slide to 69¢.
Assuming oil prices remain low, a slide of this magnitude makes a lot of a sense. The Bank of Canada might actually welcome an ultra-cheap loonie and the boost it would give Canadian exports, so would be unlikely to intervene.
Beware the volatility. On the other hand, maybe we’re not trapped in secular stagnation and the rocky rebound from the financial crisis reflects just bad policy, bad luck and the inevitable difficulty in getting over a monumental real estate bubble in much of the developed world.
If that’s the case, then rates in at least some countries are likely to rebound strongly over the next two to four years as the economic headwinds weaken. That appears to be the expectation among policy makers at the Federal Reserve. They forecast that the Fed Funds rate will rocket from near zero now to more than 3% by 2020.
The question is whether Canadian rates will follow suit. That will largely hinge on whether a strong U.S. recovery drags the Canadian economy in its wake. If so, then Canadian rates will also rise strongly and the loonie could stage a resurgence.
More likely, though, is a subdued effect in Canada as domestic manufacturers fight for a piece of the U.S. pie against newly competitive European and Mexican competitors. That could lead to a long patch of Canadian dollar weakness and low—or even lower—rates than now.
Ian McGugan is an award-winning business journalist in Toronto and the founding editor of MoneySense magazine. E-mail: email@example.com.