Canada, as a small open economy, depends to a large extent on global economic developments. Trade and capital flow linkages to its major trading partners, as well as the foreign interest rate level, are important for the Canadian economy. In our sample period, about two-thirds of total portfolio investments in Canada are made by U.S. investors. The trade share with the United States is also quite large (77% in 1998, 68% in 2006). In 95% of all currency transactions involving Canadian dollars, these are converted into U.S. dollars and vice versa. (1) These figures indicate that economic developments in the United States and its monetary policy (MP) should play an important role particularly in the development of the Canadian economy and its financial markets. There has even been discussion of creating a monetary union between Canada and the United States or unilaterally adopting a U.S. dollar peg. For instance, Buiter (1999) concludes that economic arguments favor a full, formally symmetric monetary union.
Therefore, when studying Canadian financial markets, one needs to consider economic events occurring in the United States. Gravelle and Moessner (2001) state that throughout the 1990s, Canadian market participants tended to put greater emphasis on U.S. macroeconomic data releases than on Canadian ones. Thus, one should expect U.S. macroeconomic news and MP to have a significant impact on Canadian financial markets. In addition, it is important to study MP communication in a broad sense, and not only target rate changes, as market participants, but also adjust to news conveyed in speeches and testimony by Federal Open Market Committee (FOMC) members. As U.S. financial markets react to informal channels of MP, we expect Canadian markets will, too. (2)
Our sample period, 1998-2006, includes several formal and informal changes in Canadian MP. Ever since September 1998, the Bank of Canada (BOC) has intervened in the foreign exchange market only under "exceptional circumstances." In September 2000, it introduced fixed announcement dates (FADs); previously, target rate changes could effectively occur on any business day. (3) With the introduction of FADs, the BOC became more "independent" from the Federal Reserve Bank (Fed). The BOC does not explicitly refer to any prior decisions by the Fed in its post-meeting statements after May 2000. For instance, between April 2002 and September 2004, the BOC target rate deviates substantially from the federal funds target rate (see Figure A1 in the Appendix).
This is the first paper to study the effects of formal and informal communication by the BOC as well as by the Fed on Canadian financial markets using a novel set of data. In this paper, we address four research questions:
1. Do U.S. and Canadian central bank communication (including target rate changes) and macroeconomic news have an impact on Canadian financial market returns?
2. Which type of news, U.S. or Canadian, is more relevant?
3. Does the introduction of the FAD system change agents' sensitivity to Canadian news? In particular, is there a stronger reaction to Canadian news in the April 2002 to September 2004 subsample, a period during which the course of BOC MP was different from that of the Fed, compared to reactions in other periods? This is of particular interest as the BOC followed the U.S. interest rate path closely even after introduction of the FAD system.
4. Does U.S. and Canadian news exert an influence on financial market volatility?
The remainder of this paper is organized as follows. In the next section, we summarize previous work in this area and outline the contributions of this paper. Section III describes the construction of the news dummies and explains our data set. Section IV introduces the econometric methodology. Section V reports our empirical results for bond market returns; Section VI focuses on stock and foreign exchange market returns. …