The Bank of Canada is very clear about its intention to raise rates as early as June. The key question is not about timing but rather of magnitude. At this point, it appears that the market is in a process of pricing in a significant rate increase by the Bank, with many observers suggesting that the Bank rate will reach 4% or 5% by the end of 2011. It appears that the Bank of Canada  itself is uncomfortable with this recent move by the market to discount an aggressive tightening program.

The Bank knows very well that this recovery is going to be extremely non-linear with an array of factors limiting growth and inflation in the second half of the year and into 2011.  These factors include a strong dollar, the end of fiscal stimulus, a significant softening in real estate activity following this spring, a slower pace of economic activity in the US in the second half, and the impact of higher interest rates on over-extended consumers. In fact, our consumer capability index is at a 15-year low and we estimate that consumers are now 40% more sensitive to higher rates compared to the last times the Bank of Canada raised interest rates. This environment is consistent with a gradual approach towards removing liquidity from the market with the Bank rate likely to rise to only 2.5%-3.0% by the end of 2011.

What does the coming rate hikes mean for the stock market? The common thinking is that higher rates are negative for stocks, but history does not support this claim. Looking at data going back to the 1950s we found that in the six months before the Bank started to lean into the wind, Canadian stocks historically provided, on average, a 22% annualized return (dividends plus capital gains) measured by the total return index for the TSX Composite. In the six months after a rate trough, Canadian stocks in comparison returned 8.3% in annualized terms. That’s less, on average, than in the pre-hike period, but within a per cent of the TSX’s longer term performance. Total returns were significantly negative in only one of the thirteen half-year periods after a rate trough. Stocks outshone bonds, the main competing asset class, about 70% of the time in the half year before the trough in rates and over 85% of the time in the half year after.

Along with the expected limited monetary tightening, this historical observation suggests that the coming rate hikes may well be an annoyance but are unlikely to deliver a knockout blow to equity markets.

Benjamin Tal
Senior Economist

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