The Bank of Canada's (BoC) surprise decision to cut its overnight rate by a quarter of a percentage point is a game changer for income investors. Until the Jan. 21 announcement, the general assumption was that it would raise its target rate this year in response to a strengthening economy and concerns over the growing levels of household debt. Even after the plunge in oil prices put a damper on our growth prospects, the consensus was still that the BoC would start ratcheting rates higher later this year, albeit at a slower pace. So much for consensus!
The rate cut is a clear signal that our economy is in trouble. Growth forecasts for the next two years have already been slashed, and may be downgraded further in the coming months if the price of oil keeps sliding. That is certainly a possibility, with inventories at multi-year highs and continuing to build.
So what does all this mean for your investing strategies? Here are some of the implications of the Bank's action and my suggested response to them.
Lower interest rates
Just when we thought rates couldn't go any lower, they're now poised to drop further. While the banks were slow to lower their prime rate, and then only by 15 basis points, they were quick to cut the rates on GICs. Before the BoC cut, Royal Bank was offering 2 per cent on five-year terms. Afterwards, it quickly dropped to 1.65 per cent. Now their posted rate is down to 1.5 per cent. That's down half a point from about a month ago. By comparison, the central bank's cut was only a quarter point.
According to the Bank of Canada website, the average five-year GIC rate in Canada for the week ending Jan. 21 was 1.63 per cent. By the week ending Feb. 4 it had fallen to 1.38 per cent. That's less than the current rate of inflation and the lowest we've seen in 10 years (the Bank's public records don't go back any farther). The rates on high-interest savings accounts have come down as well.
Investment implications: GICs are even less attractive now than they were prior to the latest rate cut. If you must use them, stay short term.
Higher bond prices
Just when we thought bond yields couldn't get any lower, they did. According to the BoC, the yield on the benchmark 10-year federal government bond fell from 2.36 per cent at the start of 2014 to 1.79 per cent by year-end. As of the close on Jan. 23, after the rate cut, it was down to 1.444 per cent. As of Feb. 5, it was at 1.35 per cent.
Still think it can't go any lower? Last month the rate on accounts in the Swiss National Bank was cut to minus 0.75 per cent in an effort to discourage the inflow of foreign money. A few days later, Denmark followed suit with the Danish National Bank announcing that certificates of deposit would carry a rate of minus 0.2 per cent.
Lower yields translate into higher bond prices, and that's exactly what we have seen in the first three weeks of 2015. As of Feb. 5, the FTSE TMX Universe Bond Index showed a year-to-date gain of 4.14 per cent. The Universe All-Government Bond Index was doing even better at +4.56 per cent.
For the past few years, we've been led to believe that the world was finally recovering from the Great Recession of 2008-09. That can no longer be taken as an article of faith. The International Monetary Fund just slashed its projections for global growth this year, and some areas, including Europe, are hovering on the brink of recession and deflation.
The European Central Bank and the Bank of Canada both took stimulative measures last month in an effort to counter the negative trends. In that kind of climate, a further slide in bond yields, and a corresponding increase in prices, cannot be ruled out.
Investment implications: I have always advised maintaining a reasonable bond weighting in portfolios, regardless of the circumstances. Today, that's more important than ever.
A boost for interest-sensitive stocks
Back in the spring of 2013, concerns about rising interest rates clobbered the prices of interest-sensitive stocks. Now we're seeing the reverse effect – falling rates are boosting the market values of these securities. As of the close on Feb. 6, the S&P/TSX Capped Utilities Index had gained 3.6 per cent this year. The REIT Index was up 7.9 per cent. At that point, the S&P/TSX Composite showed a year-to-date gain of 3.1 per cent.
Like bonds, these stocks react inversely to interest rate movements. Their prices fall when rates rise, thereby increasing their yields and maintaining the risk spread with government bonds. When rates fall, we see the opposite effect.
Investment implications: As long as current rate trends continue, interest-sensitive stocks will perform well. When the current situation reverses itself – and that may be months away – the price of these securities will retreat.
A lower loonie
The Bank of Canada rate cut hammered a loonie that was already badly weakened by the decline in oil prices. As a result, it now takes about $1.25 to buy one U.S. dollar at the official exchange rate (more when you add in bank charges). Our currency hasn't been this low since early 2009.
And there's no guarantee this is the bottom. Having started down that road, the BoC could cut its target rate again if the economy doesn't pick up and if inflation weakens. A further slide in the oil price would put more downward pressure on the loonie.
Investment implications: Own some U.S. dollar securities, such as high-quality dividend paying stocks.
The bottom line is that many of the assumptions we have been using for our decision-making are being turned upside down. We have to adapt accordingly.