Continued economic strengthening, concerns that inflation might rise in the future and a large amount of government debt are among the factors translating into increases in interest rates, with more likely to come.
Here are five questions that advisors – and their clients – might ask about rising interest rates:
- 1. Why are rates rising?
- 2. When will central banks raise their benchmark interest rates?
- 3. How long might the trend last and how high might rates go?
- 4. What are the economic risks surrounding higher interest rates?
- 5. What do higher rates mean for investors?
Why are rates rising?
Although a lot of the recent discussion has focused on the central bank benchmark rates (e.g., the U.S. Fed Funds rate or the Bank of Canada’s target rate for overnight funds), market rates are already rising. In March, Canadian government bond yields rose, with increases ranging from 38 basis points for the 2-year, to 40 basis points for the 5-year, to 19 basis points for the 10-year and 10 basis points for the long-term bond. At the end of the month, some Canadian banks announced increases in their mortgage rates, at least partly in reaction to the increase in bond yields. The increases aren’t confined to Canada. U.S. Treasury yields have risen over approximately the same time period by 25, 27, 18 and 12 basis points respectively.
What is behind the recent moves? To a large extent, economic data have been positive and that accounts for much of the changes. In other words, the very low and stimulative interest rates of the past year-and-a-half are much less necessary now and rates can move back toward more normal levels. Government debt is another factor. There is a lot of it, which tends to lower the price and raise the yield. Furthermore, investors are viewing the debt issued by some governments as having elevated risk, which also tends to drive up the yield. These factors apply to a lesser extent in Canada, because there is less debt and less risk than in many other countries, but as we saw during the financial crisis, global financial trends don’t stop at the Canadian border.
The third factor is much more forward looking. This is the concern that as the economic recovery strengthens, the possibility of inflation heating up also strengthens. And, here is where the central banks will enter the picture. The core function of central banks – the Bank of Canada, the U.S. Federal Reserve, the European Central Bank, etc. – is to keep inflation under control. For the Bank of Canada, that means keeping the annual rate of inflation (measured by the Consumer Price Index) between 1 and 3%. As of February 2010 – the latest data available when this article was being prepared – inflation in Canada was well within the target band but central banks will raise rates (the central banks of Australia and India have already begun to do so) because their analysis tells them if they don’t raise rates, inflation will rise in the future, possibly quite sharply.
When will central banks raise their benchmark interest rates?
The Bank of Canada is likely to enter the picture in the second half of the year. We can be pretty certain that the Bank won’t raise rates before then because the Governor – Mark Carney – has publicly committed to keeping the bank’s benchmark interest rate – the target rate for overnight funds – at its current 0.25% until mid-year, barring an unexpected rise in inflation. The exact timing of when rates rise after that date is dependent on at least a couple of things. One is how rapidly the Canadian economy grows, which is an effective proxy for how much demand for goods and services will put pressure on supply and how much inflation results. We know that economic growth picked up quite substantially in the fourth quarter to a 5% annualized rate. Even if the first quarter is a little less than that, it would still represent very solid economic growth. Although expectations around economic growth are more muted for the second half of this year, one could still conclude that the overall rate of economic growth would warrant interest-rate increases from their current very low level.
Another important issue that will be on the Bank’s mind is the foreign exchange value of the Canadian dollar. The central point here is that rising interest rates, other things being equal, are likely to result in a higher Canadian dollar. Because the Canadian economy is heavily export-oriented – approximately 35% of economic output goes to exports in a normal year – the value of the Canadian dollar has a big effect on export demand The Bank of Canada might delay raising its benchmark interest rate depending on its judgment regarding how much the currently-high currency is restricting export demand.
For how long and by how much will rates rise?
These two questions are closely related. Initially, central banks in Europe, the United States and Canada are likely to tread carefully when they begin to raise rates. In other words, they will, in effect, test the waters, while keeping a close eye on economic activity. Of the forecasts that I monitor regularly, the ones that seem most credible are those that suggest a Bank of Canada benchmark interest rate of 3.25% by the end of 2011. (I’m not sure it is terribly useful to try to go beyond that time frame.) In discussing that forecast with advisors in recent weeks, I have gotten two quite different responses. One is that moving from 0.25% to 3.25% in what could be an 18 month period is a rapid hike. The other is that relative to historic Bank of Canada benchmark rates, 3.25% is not particularly high. In fact, the average Bank of Canada benchmark rate over the last decade was 3.12%.
Next we come to the question of how much shorter-term rates are likely to rise relative to longer-term rates. The financial industry jargon would refer to the yield curve, which is simply the line drawn from very short-term rates such as the 3-month treasury bill rate right along the spectrum all the way out to 30-year Government of Canada bond yields. The increases in bond yields that I mentioned earlier give us a clue. Short rates are likely to continue to rise more than long rates. As the central banks enter the picture, they will be a strong force driving rates upward, with their influence most felt at the short end of the yield curve. Reverting to financial-market jargon, the yield curve will become considerably less steep than at present. Put another way, rates all along the yield curve are likely to rise, but longer-term rates less so than shorter-term rates.
What are the economic risks surrounding higher interest rates?
The past couple of years have acted as an important reminder that we should always think about risks. We should, therefore, ask the question: What are the risks around higher interest rates? First, let’s think of the broad economic risks. The main risk is timing. In other words, we know that economic recovery is in progress, but it is too early in the recovery to know how strong and sustained it will be. The central banks don’t want to raise rates too soon or by too much. At the same time, we know that leaving rates at current levels would almost certainly result in higher inflation down the road. This is a crucial point. Even though inflation is well within the Bank of Canada’s target bands as this article is being written, everything we have learned from the past tells us that leaving rates where they are for much longer means inflation trouble ahead. Therefore, it is important that central banks do raise interest rates.
What do higher rates mean for your clients?
Rising rates are likely to affect your clients’ total financial life – not just their investments. Higher mortgage interest rates are a good example. And, at least initially, they may have as much effect on their psyche as their financial situation. We have had very low interest rates for just long enough that some will be shocked and surprised as rate increases really take hold.
For clients who invest in fixed income purely for the coupon yield, rising rates are good news, though not good enough news that they should start ignoring asset allocation. In other words, rates aren’t likely to move high enough to solve the retirement income challenge on their own. For those who look to fixed income investments for capital gains and/or total return, the issues are more complex, involving, among other things, the extent to which the yield curve actually flattens and the arithmetic of the effect of rising rates on bond prices at various parts of the yield curve. In other words, this might be a good time to rely on the expertise of a bond fund portfolio manager.
Traditionally, the equity market view of rising interest rates was that they are not friendly. However, this is an area where generalization doesn’t serve us well. In this instance, rising interest rates will be reflective of improving economic conditions, wouldn’t seem to be a bad thing for equity markets at all. In addition, as mentioned earlier, the Bank of Canada’s benchmark may rise barely above its average of the past decade.
Conclusion: Rising interest rates may be friendlier than you might have thought
It is really important to have perspective on the interest-rate increases we are seeing and will see. First, they won’t last forever and may not go much beyond the 18 month time frame we have been discussing. Second, these are not interest rate increases intended to slow or stop economic activity in order to fight inflation. They are rate increases that will remove monetary stimulus, get rates back to more normal levels and play a role in preventing inflation from becoming a problem.
Interest rate increases over the coming 18 months will undoubtedly claim some victims. But, the broad view is that they are returning to more normal levels. And that reflects a return to more normal economic and financial market conditions. That is good news. What will be even better news is if central banks get the timing and path sufficiently correct to avoid inflation issues down the road. If they are successful, they will have done every investor an enormous favour.