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Bank of Canada Increases Rates, Promises to Monitor Potential Borrowing Risks

The Bank of Canada (BoC) today raised its target overnight rate by 0.25% to 1.0%—the Bank’s second interest rate increase this year. The timing of the increase came as a surprise to some analysts, although most expected another increase at some point this year.

Canadian economy continues to strengthen 

The Bank’s decision was largely based on its view that continued strong economic growth in Canada is becoming more broadly based and self-sustaining. Consumer spending continues to be robust, driven by solid employment and wage growth although the Bank flagged a decreased ability for the heavily indebted Canadian household to contribute to overall growth.

Recognizing that higher interest rates can contribute to higher debt burdens for Canadians, the Bank stressed that future rate decisions would not be “predetermined”, and promised to closely monitor the economy and any potential risks related to the cost of borrowing.

“Given elevated household indebtedness, close attention will be paid to the sensitivity of the economy to higher interest rates”, the Bank said in its statement, taking a cautious tone.

Market reaction to announcement

Immediately following the announcement, the Canadian dollar jumped to above 82 cents – its highest level since June 2015. The Toronto Stock Exchange’s S&P/TSX composite index was trading higher in advance of the announcement, and then turned negative following the interest rate increase as oil prices rose.

Core inflation remains low

When an economy produces more goods and services than it is sustainably capable of delivering, inflation is created. The Bank aims to keep inflation around 2% for the total consumer price index (CPI).  

The BoC’s mandate is to maintain core inflation between 1-3% with a target of 2%. Even though core inflation remains low, 0.9% in the 12-months through July, anticipated inflation is more robust, providing support for today’s decision.

Effect on bond yields

Immediately following the rate hike announcement, Government of Canada bond yields increased by only a modest amount as the continuing strength of the Canadian economy had already been partially factored into market prices. Gross Domestic Product (GDP) results for the second quarter of 2017 were released on August 31, and with stronger than expected 4.5% annualized growth, bond yields immediately increased in anticipation of the pending BoC rate increase.

What does this rate increase mean for your portfolio?

The immediate impact of today’s rate decision on MD portfolios and funds is minimal. Our fixed-income funds maintain an overweight exposure to corporate bonds (which are less sensitive to interest rate changes), focus on protecting capital, and we maintain an active allocation to foreign and non-investment grade holdings, which are not directly affected by changes in domestic interest rates. We remain tactically underweight Canada in our portfolios, and expect that the stronger Canadian dollar resulting from higher interest rates will continue to weigh down on the Canadian stock market.

As Canada’s economy continues to grow, slightly higher interest rates indicate confidence in our economy. Read more about what higher interest rates could mean for you. We encourage you to contact your MD Advisor if you have any questions.