To quote the most recent winner of the Nobel Prize for literature, Bob Dylan, “the times, they are a-changin’.” In capital markets, the U.S. Federal Reserve Board is likely to raise the interest rate it charges banks to borrow money overnight to maintain reserves — a key indicator for all other interest rates in the economy. This increase was announced after the Fed’s Open Market Committee met in mid-December.
Here is what is going to happen and what is already happening in advance of the expected announcement:
- Short-term interest rates in the U.S. will rise by about a quarter of a per cent.
- Long-term rates for bonds and mortgages with terms of five or more years will tend to rise by a comparable amount.
- The line connecting all yields for all periods from one day to 30 years, called the yield curve, will tend to flatten, an omen for economic growth restrained by the central bank.
- Existing long bonds, those that have terms of 10 or more years, will start to lose value as new bonds with higher interest rates hit the market. Existing bond prices will fall a little.
- Companies with a great deal of debt coming due in a year or two will find their stock prices falling as investors anticipate that higher interest rates will reduce their profits. Utilities, railroads, insurance companies and banks are among the most vulnerable stocks.
- Bank share prices will eventually rise as investors perceive that term spreads (the difference between borrowing costs and lending rates) will grow.
- Insurance company stocks will recover as higher rates on government bonds (what insurance companies use for life insurance investments) raise profits and allow better deals for customers seeking new or renewed insurance policies.
Canadian interest rate increases are going to lag U.S. rate rises. In an Oct. 19 announcement, Bank of Canada Governor Stephen Poloz said Canadian rates would not rise in synch with U.S. rates. Slow economic growth, low energy prices, low non-energy export growth and a fear of triggering a made-in-Canada recession induced the BoC to hold the line. There was a discussion of lowering rates to stimulate the economy, but, reportedly, the BoC did not want to add fire to hot real estate markets in Vancouver and Toronto. On the other hand, tighter house mortgage rules are expected to reduce economic growth by as much as 0.3 per cent per year. The defensive stand of the Bank of Canada implies that Canadian interest rates will not begin rising until mid-2018 and that is if economic growth picks up rather smartly.
Until Canadian interest rate catch up to those in the U.S., the loonie will tend to soften. Canadian interest rates will eventually rise. They have always moved in synch with U.S. rates over long periods; over a period of five to 10 years, Canadian rate trends are going to match U.S. trends.
For investors in what is going to be a rising interest rate environment, the rate boosts that are coming imply a need for major portfolio review and adjustment.
As interest rates rise, solid, high yielding stocks will tend to be sold off to buy bonds. At first, there won’t be much competition between a telecommunications stocks like BCE Inc. with a 4.5 per cent yield taxed at a relatively low rate courtesy of the dividend tax credit and a five-year Government of Canada bond with a five per cent yield fully taxed. But government bond yields and corporate bond yields will rise along with the rising overnight rate. The move to higher rates will not be race to the top. It will be like watching a ballet in slow motion with many players moving carefully to avoid stepping on other dancers’ toes.
Still, in a couple of years, there will be a new hierarchy of desirable assets: for off-farm investors, Government of Canada bonds could have rates of three or four per cent for five years. Add one or two per cent to that for senior issues of the biggest and more trusted of Canadian corporations. Junk bonds tend to move in their own cycles, but it is a sure thing that they will have to add one or two per cent to the lower levels of investment grade bonds. Figure six to eight per cent for “good” junk, often just non-rated debt from solid but smaller issuers. But remember that corporate bonds are not as liquid as stocks.
It is easier and safer to buy into diversified bond mutual funds with annual management expense ratios of less than one per cent or exchange traded bond fund with MERs of one-third of one-per cent or less. But by all means consider (though not necessarily buy) bonds, but consult an investment advisor about selling and about costs.
Higher interest rates are coming to Canada, but not for at least 18 months. What happens in the United States will happen here. Watch U.S. investment markets for a preview and keep some cash on hand to buy into the bargains that will appear as rising interest rates known down some stocks and bonds.