Rate Hikes Coming—Be Ready

Barring a total economic disaster, the U.S. Federal Reserve Board will begin raising interest rates later this year, perhaps as early as September.

That was made clear recently by chair Janet Yellen in a speech in Providence, Rhode Island. Reuters quoted her as saying: “If the economy continues to improve as I expect, I think it will appropriate at some point this year to take the initial step to raise the federal funds rate target”

This comes as no surprise, of course. The Fed has been signalling for months that it wants to break out of the near zero rate environment that has prevailed since the financial crisis of 2008. It’s been called the most choreographed rate hike in history.

The only thing that’s delayed it has been the stubborn refusal of the American economy to start functioning on all cylinders. According to the Department of Commerce, the American GDP contracted by 0.7 per cent in the first quarter. The harsh winter, strong U.S. dollar, weak consumer spending, and slow global growth all bore a share of the blame for the weak result.

So what happens when they do? Here’s what to expect.

A gradual approach. There won’t be any sudden spike higher. The Fed will move cautiously, with a close eye on market reaction. The initial hike will only be a quarter-point and then the Fed may pause for a few months to assess the impact. The last thing Ms. Yellen and her colleagues want is to create a new financial crisis or a stock market plunge. It will probably take a few years before interest rates return to historic levels – if they ever do. In March, Fed officials reduced their median estimate for where the rate would stand at year-end to 0.625 per cent. Based on Ms. Yellen’s latest remarks, I think 0.5 per cent is more realistic.

A stronger U.S. dollar. The last thing the U.S. needs right now is further strengthening in their dollar. The high greenback is already costing multi-national U.S. companies billions of dollars in lost profits and making American goods less competitive in foreign markets. A Fed rate hike will make the greenback even more attractive to offshore investors seeking a safe haven, driving the currency higher. That’s another reason to tread carefully.

A weaker loonie. The Bank of Canada won’t be able to match the Fed’s rate increase. Our economy is much more fragile due to the chaos in the energy sector as a result of the plunge in the oil price. In fact, there is still speculation that our central bank may decide to cut another quarter point to stimulate growth. A rate hike is nowhere in sight. In this scenario, the loonie is almost certain to decline when the Fed finally moves. Only an unexpected rebound in the price of oil could change that, and that looks highly unlikely.

So how should you respond to what’s coming? Here are my suggestions.

Don’t panic. It’s important at this stage in the cycle to maintain perspective and remember why you own the securities you do. As long as the cash flow continues, income investors should not be overly concerned about the change in the market price of a security. The quarterly dividend will still be paid whether the market prices a stock at $40 or $50.

Focus on dividend raisers. The best income stocks to own during periods of rising rates are those with a solid history of regular and significant dividend increases. Companies that actually announce a target for dividend hikes are especially attractive. For example, Brookfield Infrastructure Limited Partnership (TSX: BIP.UN, NYSE: BIP) aims for an annual distribution increase of between 5 per cent and 9 per cent. This year’s hike was even better, at 10 per cent.

Emphasize short-term bonds. As I have said many times in the past, you should always keep some bonds in your portfolio. However, you’ll have to expect some capital loss in a rising interest rate environment. The shorter the term to maturity, the less the risk. And remember that all bonds held to maturity are redeemed at par value.

Take advantage of buying opportunities. The expected shakeout in interest sensitive securities will open up some bargains. As share prices drop, yields will rise, assuming a company maintains or increases its payout. For example, BCE shares closed on May 29 on the TSX at $54.50 to yield 4.77 per cent on an annualized dividend of $2.60. If the share price should pull back to, say, $50, the yield on new purchases would be a more attractive 5.2 per cent. And BCE is one of the companies with a record of regular dividend hikes.