Canada’s interest rates are currently lower than peer countries’ rates. With a 2.25% benchmark interest rate, compared to 4% in the U.S. and 7% in Mexico, Canada has by far the lowest rates in North America.
On one level, this fact would appear to be a negative. Low interest rates are associated with currency depreciation, which lessens currency holders’ purchasing power abroad. On the other hand, low interest rates stimulate investment and exports. In this article, I explore the benefits of Canada’s lower interest rates to the nation’s citizens, investors, and companies.
A boon to exports
A country having low interest rates benefits that country’s exporters, as lower rates are associated with lower currency values. When a nation’s central bank cuts rates, investors typically respond by moving money out of that country and into a country that offers higher yields – a financial strategy known as the “carry trade.”
When the carry trade works and causes depreciation of the lower-yielding currency, it does erode the currency’s global purchasing power. A known real-world consequence of this is people finding their dollars worth less when they travel abroad, something that Canadians who travel to the U.S. are well aware of. However, the currency depreciation also benefits the country’s exporters, as it allows them to undercut sellers in countries with stronger currencies. This fact helps explain why, despite all of Trump’s tariffs, Canada nevertheless had a $6.6 billion surplus with the U.S. last November.
A stimulus to the economy
Another positive effect of low interest rates is their tendency to stimulate the economy. When interest rates fall, borrowing gets cheaper. A result of this is that people have increased access to funds with which to spend and invest. When rates fall, people become more able to:
- Start businesses.
- Invest in existing businesses.
- Buy homes.
- Spend money on discretionary goods and services.
As a result of the above effects, GDP and corporate profits both tend to increase when rates fall.
An asset booster
A final positive effect of low interest rates is their tendency to increase asset prices.
The “fair value” of an asset is all of its future cash flows discounted at the opportunity cost of capital. “Opportunity cost” is expressed as a rate; the higher the rate, the lower the value of the asset, as discounting involves dividing by one plus the rate. So, when rates fall, asset prices should rise.
A stock that benefits from low rates
A classic example of a company that benefits from low interest rates is Fortis Inc (TSX:FTS). Fortis is a capital-intensive utility company that has to borrow funds extensively in order to run its business. The company has $32 billion worth of long-term debt, incurring $1.5 billion in annual interest expense. The effective interest rate here is 4.6%, which is relatively high compared to Canada’s current benchmark policy rate (2.25%).
Currently, Fortis’ interest expenses are a major drag on its profitability, taking a $1.5 billion bite out of profit each quarter. However, interest rates are much lower than they were when Fortis initially borrowed the funds just mentioned. When it goes to refinance its debt, Fortis will probably be able to pay much less than the 4.6% interest rate it’s currently paying.
The end result?
Wider profit margins and an overall more profitable business.
That’s the power of low interest rates, perfectly illustrated.
