The Bank of Canada may be accelerating the pace of interest rate cuts amid concerns about the economy's strength, but for investors, falling interest rates look positive for Canadian stocks. When it comes to bonds, the picture is murkier.
While stocks are expected to benefit from lower interest rates and the Bank of Canada's commitment to supporting growth, prices are rising for bond investors. This offers potentially positive returns for bond funds, although the returns become less attractive from an income perspective. These lower bond yields could also make dividend stocks more attractive.
Wednesday's cut marks the fourth consecutive cut by the central bank this year, after raising interest rates to a high of 5% last year. The bank cut its overnight interest rate by half a percentage point from 4.25% to 3.75%. In its latest monetary policy announcement, the Bank of Canada's board cited increasing signs that the Canadian economy and labor markets are weakening, perhaps by more than what is needed to meet the 2% inflation target.
Some market observers now estimate there is a 50% chance that there will be a similarly large decline in December. The conclusion that the door to future cuts is wide open (at least for now) should give the market some of the relief and policy visibility that investors value.
What interest rate cuts mean for stocks and bonds
When interest rates fall, bond yields tend to fall. When yields fall, returns from bonds fall, forcing investors to look for alternatives.
According to Dustin Reid, chief fixed income strategist at Mackenzie Investments, Canada's monetary policy is on a different path than that of the United States, whose economy continues to improve, due to the struggling economy, frequent interest rate cuts and falling bond yields. “The Bank of Canada [rate cut] “Action – and likely further action – could create an opportunity for Canadian bonds to outperform U.S. bonds in the coming months,” he says.
Sadiq Adatia, chief investment officer at BMO Global Asset Management, says lower interest rates “allow stocks to remain stable even when earnings start to decline, as valuation metrics can remain higher.”
Dividend stocks might look more attractive
Dividend paying stocks become more attractive in such scenarios as they offer the potential for regular income and capital appreciation.
According to a CIBC stock analysis, around a quarter of a trillion dollars is in excess time deposits and money market funds. It adds that Wednesday's jumbo cut pushed three-month Treasury yields below 3.6% for the first time since October 2022.
“A third of these excess term deposits will expire within the next two quarters.” [and] Combined with excess assets in money market funds, this could unlock over $100 billion of liquidity in dividend stocks by mid-2025,” the note said.
Which stocks will benefit from falling prices?
Lower interest rates are particularly favorable for sectors sensitive to falling borrowing costs, such as: B. Finance, real estate and utilities with high dividend payouts – key drivers of the Canadian economy.
“Surveys and anecdotal data suggest that this 50 basis point cut was a key element in bringing some potential homebuyers back into the market, so housing and related industries are likely to receive more of a boost from Wednesday's announcement as well as the proposal . “Cutbacks are being planned,” explains Reid.
Adatia believes that everything related to consumer spending (staples and consumer goods) will ultimately benefit, adding that it will take time for consumers to be strong. In the short term, however, some of the benefits of lower interest rates may be dampened by uncertainty about jobs and the broader economic outlook.
Interest rate cuts take time to impact the economy, says Claire Fan, an economist at the Royal Bank of Canada in their post-cut comments suggesting the central bank needs to cut more aggressively. “Even if interest rates fall, many borrowers can still expect increasing debt payments in the coming years,” she says. “This suggests that it is more urgent to bring forward the easing.”
However, an acceleration in monetary easing could have a significant impact on the foreign exchange market. For example, the faster pace of cuts tends to cause the Canadian dollar to lose value relative to its U.S. counterpart.
“If there is an expansion in U.S.-Canada interest rates, the Canadian dollar could also fall further,” Reid says, adding that “sustained all-time highs in the stock market would likely mitigate a significant sell-off in the Canadian dollar.”
The author(s) do not own shares in any of the securities mentioned in this article. Learn about Morningstar's editorial policies.
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