It is inevitable that interest rates will rise, but when that will happen, nobody knows. On Sept. 17, the U.S. Federal reserve announced that, yet again, the inevitable increase would be postponed, perhaps to December, perhaps beyond. Until then, the Fed will keep interest rates at the emergency level that has prevailed for half a decade and Canadian rates, too, will remain at their current levels beginning with 0.50 per cent for overnight loans to the chartered banks.
Timing is everything. And that is the problem. Under-chair Janet Yellen, the Fed has deliberated over raising rates for more than a year, waiting for employment figures and inflation data to signal the kind of economic growth that meets their expectations. U.S. unemployment is down to 5.1 per cent, which is a pre-recession level (it’s seven per cent in Canada), U.S. gross domestic product is rising at 2.4 per cent at annualized rates — respectable though not breath taking (it’s an anemic 1.4 per cent in Canada), and business has in many ways gone back to its usual pace. So why the wait for what everyone knows must happen one day?
A slow rise
Acting prematurely could trigger a new mini-recession, which the Fed has achieved in the past with bad timing, and, at worst force it to back down, cutting rates and losing a lot of street credibility. Thus the plodding timing. Moreover, Ms. Yellen and other Fed officials know that they are dealing in a token and they want to get it perfect. They hesitate to err even on the side of the inevitable.
Rates must rise in the U.S., where overnight interbank loans remain at 0.25 per cent at annual rates. The bottom line reason is that the emergency of 2008 triggered by the failure of Lehman Brothers is long past. When rates do start to rise, yield curves, which trace the rates paid by each class of bond from governments to junk from one day to 30 years, will shift upward and perhaps flatten a little bit with the low end rising more than the top end.
The wait is maddening and, what’s more, it doesn’t matter very much. The dance of the yield curve is a ballet in monetary theory. In the real world, mortgage loans will still be about where they are, store credit cards will still cost you 29 per cent if you run a credit balance, and car loans will be whatever charade the manufacturers want to play to convince you to buy on time.
Behind the picking of daisy petals, indecision of the Fed is a deeper problem. The world is flirting with deflation. Within the G-7, consumer prices have risen just at 0.2 per cent on average in the U.S. 0.2 per cent in the U.K., 0.2 per cent in Italy, 0.2 per cent in Germany, 0.3 per cent in Japan, and 0.2 per cent in France this year. There is no need to raise interest rates to battle inflation for there isn’t any. Canada’s inflation rate is about 1.3 per cent at the latest measure in July, the result of higher imported food and other goods costs caused by the Bank of Canada’s ruthless pushing down of interest rates. We are the outlier in the G7, yet the Bank of Canada would probably push down rates further from the present 0.5 per cent overnight rate in its endless but futile attempt to get orders for Ontario factories.
After the rise
What will happen in capital markets when rates rise? A higher interest rate in the U.S. will cause more money to flow to U.S. Treasury bonds. The inflow of funds will raise the U.S. dollar and push down the Canadian dollar, Sterling and the Euro. As those currencies decline, the costs of living will rise. You could say that the Fed will be exporting inflation, but that’s only a side effect.
The effect on Canada will be that our exports — grains, potash, copper, iron, and so on — will be cheaper in Canadian dollar terms. Most export commodities are priced in U.S. dollars, so a higher dollar translates as more money for producers, farmers included. Meanwhile, input costs in Canada, which are substantially priced in Canadian dollars, will be cheaper.
The increased profitability of farm and other exports will be short lived, for the Bank of Canada will, as it always has, follow the Fed after a few months. Our economies are too closely linked for interest rate policies to diverse too much for too long. There will be an uptick in the Canadian bank rate, maybe 0.25 per cent.
A quarter of a point of interest will not change the world, yet importers will likely use the occasion to jack up the prices of canned American peaches and other imports. The way to fight the increased cost of goods is, of course, to refrain from buying.
With the world economy sagging and close to deflation, it will be a very long time before interest rates return to the level of 2000 when a 10-year Government of Canada bond bore a respectable coupon of 6.4º per cent. Monetary policy research suggests that we are in for another 30 years of very low rates and probably low growth of the world economy.
So what is the issue with interest rates rising one fourth of one per cent perhaps before Christmas? It is symbolic at most. Says James Hymas, head of Hymas Investment Management Inc., a Toronto-based specialist in preferred stock investing, “the effect on the Canadian economy will be minimal. But it will be warning shot for the market saying that rates will be low forever. We are not out of the woods yet, so the Fed’s move would be symbolic saying we are finally seeing the light at the end of the tunnel.”
The move by the Fed and, eventually, by the Bank of Canada will have consequences for investors, even if in substance a slight rate increase is of little significance on its own. The market for government bonds, which is exquisitely sensitive to rate changes, will mark down all existing issues with long bonds dropping the most. This matters a great deal to bond traders, but for buy and hold bond investors who keep their bonds to maturity, it matters little. Government bonds will still pay face value when their time is up. On the other hand, corporate bonds could gain value if investors take the rate rise as token of improving business conditions and reduced credit risk.
The Fed’s moment to raise rates will come again in December and the waiting game will begin again. The case for a rate rise will be what it is now — the end of the 2008 market meltdown. The case for waiting will remain psychological — why seem nasty just as Christmas is approaching. On these delicate matters capital markets wait.
And yet there would be some market effects when it finally happens. Companies with a great deal of debt, such as public utilities, could suffer while those with little debt, such as technology issues, could rise if the rate rise implies good times ahead. In the end, the quarter point rate rise that may start a cycle of rising rates will be a token of what is to come. That is why what is so little seems to matter so much.