Hedge your bets

Stocks and rate cuts

Interest rates are falling – again! That’s either good news or bad news, depending on how you invest.

It’s bad news if you’re considering putting money into fixed-income securities, like GICs. But it’s good news if you invest in certain types of stocks or in income trusts.

The U.S. Federal Reserve Board cut its key rate by a quarter-point on June 25. On July 15, the Bank of Canada will announce its position on its target overnight rate, which is currently at 3.25 per cent. It appears likely that our central bank will follow the Fed’s lead and chop our rate by at least a quarter-point.

Such a move would mark a dramatic shift in the stance of Bank of Canada Governor David Dodge and his colleagues in the space of just a few weeks. It wasn’t very long ago that Mr. Dodge was grimly warning of a series of interest hikes through the summer and fall to combat what he viewed as a new inflationary threat.

Now, however, no one in Ottawa seems to be uptight about inflation. Instead, the big worries are an economy that is rapidly decelerating and a Canadian dollar that has gottetoo big for its britches.

Finance Minister John Manley told us in late June just how serious the economic damage has been. He revealed that the country’s growth rate this year will be about a full percentage point less than was forecast in the February budget, and that the federal surplus would be lower than anticipated, due to such factors as SARS, mad cow disease, and the rising loonie.

In these circumstances, the pressure is strong on the Bank of Canada to ease rates. Such a move would serve a dual purpose: it would signal foreign investors and currency speculators that the Bank does not wish to see the loonie rise any further and it would act as a stimulant for our sagging economy.

In anticipation of a possible rate cut, many investors have been reaping profits, even though they may not fully understand why.

Most people know that lower interest rates are inherently good for bonds. But they may not realize that they also tend to push up the market price of interest-sensitive stocks and income trusts. In fact, we are already seeing evidence of this.

Many interest-sensitive stocks like TransCanada Corporation (formerly TransCanada PipeLines), Brascan Corporation, and Canadian Utilities have been very strong in recent weeks. So have the more stable and dependable income trusts, like RioCan REIT, Davis + Henderson Income Trust, and TransCanada Power LP.

The principle at work here is the same one that tends to drive bond prices higher when interest rates fall: the dividends and distributions paid by these securities look even more attractive in the context of lower rates, thereby attracting a new inflow of cash that drives the share price higher.

If you own any of these securities (all of the examples cited are current recommendations of my Internet Wealth Builder newsletter), then you already reaped a windfall profit even before the central bank has made its official decision. The bad news is that the party appears to be over, at least for now. The latest round of rate cuts has already been factored into the price of the shares. So don’t be too quick to jump in at this stage, unless there are other reasons to do so.

What happens next will depend on how monetary policy evolves in the coming months. If the economy continues to weaken and more rate cuts appear to be in order, interest-sensitive stocks and income trusts will be pushed higher. On the other hand, if we see renewed economic growth in the fall, as some economists are predicting, it will be bad news for these securities.

That doesn’t mean that you should be trading in and out of these securities, unless there is a valid reason to do so. In many cases, they are core holdings. But it is important to understand that the underlying forces that drive the market price don’t always relate to the financial fortunes of the specific company or trust. So don’t get too elated by a big upward move or too depressed by a sudden drop in the share price of your favourite interest-sensitive security. If the fundamentals remain strong, stay with it. (July 2003)

This article originally appeared in the Internet Wealth Builder, a weekly electronic newsletter featuring investment advice from some of Canada’s leading experts and edited by Gordon Pape. For information and special 50plus.com rates on investment books and newsletters, go to http://www.buildingwealth.ca/promotion/50plusproducts.htm