Fed rate hike fears ripple through Canada, world

Published Thu, Jul 16 20155:49 PM EDTUpdated Fri, Jul 17 20159:11 AM EDT

Patti Domm @in/patti-domm-9224884/@pattidomm

While Janet Yellen was telling Congress on Wednesday the Fed hopes to raise interest rates this year, the Bank of Canada was busy announcing a rate cut and downgrading the outlook for its sagging economy. The two events are not unrelated, and Canada's tale is a forewarning of how a U.S. policy transition is already sending ripples around the world at the same time tumbling commodities prices are biting into growth. Canada's message became particularly chilly when its central bank governor, Stephen Poloz, said the economy has now contracted for a second quarter in a row, and that the growth forecast was downgraded for the year to just 1.1 percent. The commodity-linked currencies of Canada, New Zealand and Australia have all made new post-2009 lows against the U.S. dollar, and the central bankers in those countries have all been cutting rates as the U.S. moves to lift off from zero for the first time in six years. "I think it's like a scissors, and both blades are opening. You have the U.S. tightening, and these countries are easing. I think all three of them are easing not because of deflation, but because they have weak growth," said Marc Chandler, chief currency strategist at Brown Brothers Harriman. The twin worries of a slowing China and the potential for Greece to hit Europe's economy have added to weakness in commodities, and the stronger dollar has exacerbated the situation. With the Fed about to boost rates for the first time in nine years, the trends could continue and hurt commodity-exporting countries from Brazil to Norway and Russia. "They're turning in the wringer. In the 2008 period, those countries hardly noticed a recession. Now it's their turn," said Bob Doll, Nuveen Asset Management's chief equity strategist and a senior portfolio manager. The Bank of Canada reduced its key interest rate by 25 basis points to 0.50 percent, calling it "insurance" against falling oil prices. The decision to cut for a second time, however, was also worrisome since it was due to weak performance in not only energy but nonenergy exports in the second quarter. "I think it is significant. I think the message implied that Bank of Canada welcomes a weaker Canadian dollar. I think they're hoping some of the work will be done by the Fed. If the Fed raises rates, it will weaken the Canadian dollar," said Vassili Serebriakov, currency strategist at BNP Paribas. "If the Fed delays, it will be prepared to do more." A weaker Canadian dollar makes Canadian exports more appealing, and in theory should help lift the economy, even as imports become pricier. Chandler said Canada's central bank has also suggested it could boost its economy through quantitative easing, or asset purchases, in addition to the rate cut. The Canadian dollar could go to $1.30 by the first quarter, and weaken even further after that, he said. "As the market anticipates the Fed hike, and another easing from Canada, that's when the jaws open widest," said Chandler. "We have a New Zealand cut next week. ... People are expecting the RBA ( Reserve Bank of Australia ) to cut, but it may not be until August." Australia's central bank made a surprise 25 basis point cut in February, followed by another in May, but it has been holding rates steady since then. Chandler said the countries are suffering from weaker prices for their exports. "And for what they're importing, the price is increasing," he said. "When we were in the commodity super cycle it worked in reverse. They had positive terms of trade shock, and now they have a negative terms of trade shock. ... Ultimately during the commodities super cycle, these countries did not diversify." Read More 10 stocks that almost always beat on earnings He said for New Zealand, China is a big import market for its milk powder and Chinese imports of milk are down about 60 percent this year. "Milk powder counts for about 7 percent of GDP," Chandler said, adding that when New Zealand held its last milk auction, prices were down about 13 percent. Australia, also reliant on China, exports iron ore, food, fuel and manufactured goods. "Since the 2008 credit crunch, it's only been the commodities central banks that have had positive rates. They were enjoying the boom of China, and now China has slowed down," said Boris Schlossberg of BK Asset Management. "They're all reversing course, and they're getting the biggest punishment in the currency market." Barclays strategists, in a note Wednesday said they expect New Zealand, after a report of weak inflation this week, to take the cash rate to 2.5 percent by the end of this year, reversing all of last year's rate hikes. "Previously, we had expected the RBNZ to cut by 25 bps in both June and July given underlying inflation and a weaker outlook for growth as the terms of trade falls further," they wrote. Chandler said the currency market is now focused on diverging central bank policy, after trading on Greece and China in recent weeks. Fed Chair Yellen, he said, also changed her tune. "She changed this week from (comments in) March or June. Before they were attributing the decline in exports to the strong dollar. This week, she recognized it's slower world demand," Chandler said, but she also noted the U.S. economy is resilient. Chandler said the Fed is expected to raise rates slowly, not just because of the potential impact on the U.S. economy but because of the delicate balance in the global arena, where U.S. rate hikes could sting weakening economies as they try to restart their economies. And a too-strong dollar could hurt U.S. exports too much, so the Fed, as it heads to its first interest rate increase, has to move carefully. As for the commodities economies, just the right dose of U.S. central bank rate hikes could help. "The Federal Reserve will raise rates before these countries can raise interest rates. Their currencies will depreciate and that's how they'll balance growth," he said. A takeaway for investors: Chandler said Latin American countries are commodities exporters, and Asian markets are importers so it should be negative for Latin American ETFs and positive for select Asian ETFs.

Stephen Poloz, governor of the Bank of Canada

Cole Burston | Bloomberg | Getty Images

The two events are not unrelated, and Canada's tale is a forewarning of how a U.S. policy transition is already sending ripples around the world at the same time tumbling commodities prices are biting into growth.

Canada's message became particularly chilly when its central bank governor, Stephen Poloz, said the economy has now contracted for a second quarter in a row, and that the growth forecast was downgraded for the year to just 1.1 percent.

The commodity-linked currencies of Canada, New Zealand and Australia have all made new post-2009 lows against the U.S. dollar, and the central bankers in those countries have all been cutting rates as the U.S. moves to lift off from zero for the first time in six years.