Interest rate spread could hit Canadian businesses

By John McCrank

TORONTO, Jan 22 (Reuters) - Life could soon get a little tougher for some Canadian businesses, as the differential between interest rates in Canada and the United States widened on Tuesday and could grow even more by the end of next week.

In an emergency move, the U.S. Federal Reserve slashed its key lending rate by 75 basis points, to 3.50 percent. That was followed by a milder 25 basis point cut by the Bank of Canada, in a scheduled announcement, putting its overnight rate at 4.00 percent.

Higher interest rates, compared with the United States, will give support to the Canadian dollar, which has already been causing pain for manufacturers and exporters. Borrowing costs will also be higher in Canada on a relative basis.

A Reuters poll showed that 12 of 17 U.S. primary security dealers expect another cut of 50 basis points from the U.S. central bank on Jan. 30, its regularly scheduled meeting day.

"I think the market is prepared for a 50 (point cut) from the Fed at the end of the month and that would further emphasize the disparity between the two central banks and create a slightly different borrowing environment," said Eric Lascelles, chief economics and rates strategist at TD Securities.

If the Fed cut goes ahead, that would take the spread between interest rates to a full percentage point, at least until the Bank of Canada next sets monetary policy in March.

Some analysts are calling for a 50 basis point cut by the Bank of Canada in March but, beyond that, the bank's hands may be tied.

"The BoC is quick to mention that the economy currently continues to operate above its production capacity so the scope for further rate cuts remains somewhat limited by this fact," said Stewart Hall, market Strategist at HSBC Canada.

C$ STRENGTH, EXPORT WEAKNESS

A differential of one percentage point in North American interest rates would not be unprecedented. That was the case as recently as 2006, but some Canadian businesses are still reeling from the rapid rise of the Canadian dollar, and more pain may be in store.

The currency rose a hefty 17.5 percent against the U.S. dollar in 2007, walloping Canadian manufacturers and exporters who found it increasingly hard to compete in the U.S. market.

The United States buys around 75 percent of Canadian exports.

Verbal intervention by government and central bank officials, along with a 25 basis point cut to the overnight rate in December, and some soft domestic data, helped sap some of the currency's strength.

By Monday, the Canadian dollar had fallen over 12 percent from its modern-day high of US$1.1039, hit in November, and was around 97 U.S. cents on Tuesday.

But the Canadian dollar rose after the central bank announcements and more strength may be in store.

George Davis, chief technical strategist at RBC Capital Markets said in a note that a close above 97.32 U.S. cents by the Canadian dollar would point toward a reversal in the recent trend to softness.

The next short-term target for the currency would be 99.37 U.S. cents, he said.

($1=$1.03 Canadian) (Editing by Rob Wilson)