Rising interest rates will temper global economic growth and will shape the performance of financial markets in the coming quarters, according to economists with TD Bank.

“A global rebalancing in monetary policy is underway, and the Bank of Canada will join the fray this summer,” says TD Bank’s chief economist Don Drummond.

The June issue of the TD Quarterly Economic Forecast predicts that the global economy will ride out the higher interest rate environment remarkably well, but financial markets could experience greater volatility as investors adjust to the new reality and equity markets are unlikely to replicate the double digit gains of the past few years.

In the months ahead, the European Central Bank, the Bank of Japan, the Bank of England, and the Bank of Canada – every G-7 central bank with the exception of the U.S. Federal Reserve – will increase their policy rates, says TD Economics. And, while the Fed is likely to remain on hold, this is a tighter stance to policy than financial markets had expected until only a few weeks ago when rate cuts were anticipated.

“While the global economic expansion will be dented by the rebalancing in monetary policy, it should not be thrown off the rails,” says Drummond. The fallout from higher rates in the near term should be largely felt in the second half of 2008 and early 2009, with world real GDP slowing to a still robust 4%.

In Canada, the Bank of Canada is clearly concerned about price pressures and upward drift in core inflation away from the bank’s 2% target, TD Economics says. Given these conditions, the bank is poised to raise rates, likely on July 10 and September 5.

The tightening in Canadian monetary policy will likely contribute to a Canadian dollar averaging US96¢ in the second half of this year. The one-two punch of higher interest rates and Canadian dollar will lead to a slower pace of domestic growth and a 2.5% increase in real GDP in 2008.

“As a result, 2.5% economic growth may be the best that Canada can do, and there is a risk that the Bank could be forced to engineer a weaker performance with even higher interest rates if Canadian productivity does not improve on a sustained basis,” says Drummond.


TD Economics says the financial implications of the global rebalancing of monetary policy will be far reaching. The key financial themes include:

  • The return on cash products will rise in tandem with central bank rate hikes.
  • Higher short-term rates will boost bond yields, but the impact should be extremely limited since markets have already priced in much of the future policy tightening and inflation should remain tame.
  • Equity markets will be adversely affected in a number of ways. First, higher interest rates will make fixed income products more attractive, while also making equity valuations look more expensive. Second, higher interest rates will lead to softer corporate earnings growth. Third, commodity prices are expected to dip as global growth moderates, but tight supply should keep prices for energy and many other products at very profitable levels. Increased borrowing costs may also temper the recent explosive pace of mergers and acquisitions.

“Overall, equity markets are expected to advance, but returns are likely to be in single digits and investors should be braced for increased volatility,” says Drummond.