Interest rates on hold

So the Bank of Canada has come to the end of the current tightening cycle. Good thing! If they had continued to push rates even higher, the loonie might have hit par with the U.S. dollar before year-end, which would have left our beleaguered manufacturing sector screaming even louder than ever. Even with the pause, our dollar strengthened in the days immediately following last month’s announcement.

The statement that accompanied the May rate announcement was as categorical as these things get, saying that “the target for the overnight rate is now at a level that is expected to keep the Canadian economy on the base-case path projected in the April Monetary Policy Report (MPR) and to return inflation to the 2 per cent target”. However, the governors left themselves a little wiggle room by saying that they will continue to monitor domestic and international economic activity to determine if any policy change is required.

It’s unlikely that will happen and if it does, the more likely hypothesis is that the central bank would lower interest rates rather than raise them further. Although the world economy continues to look strong, theris a general expectation that high oil prices will eventually result in a slowdown, the signs of which could become apparent later this year.

As far as the Canadian dollar is concerned, the odds are that it will continue to rise in value despite the pause in interest rate hikes. This is due largely to a combination of high oil prices and continued weakness in the U.S. dollar due to the twin trade and fiscal deficits. Last month, the OECD (Organization for Economic Co-operation and Development) issued a report in which it warned of the dangers to Europe in what it referred to as “unavoidable” adjustments relating specifically to the U.S. balance of payments and trade deficits. The report said that some experts believe the result could be a decline of one-third to one-half in the value of the U.S. dollar against the euro. The greenback is also widely expected to weaken against the key Asian currencies, particularly the Chinese yuan, which is seen as being undervalued by as much as 30 per cent, and the Japanese yen. Of course, this process will happen over time, perhaps several years – we aren’t going to see a sudden collapse of the greenback.

Any further readjustment in the exchange rate with the Canadian dollar will not be as dramatic as the impact in Europe and Asia due to the fact our currency has already appreciated significantly against its U.S. counterpart. Nonetheless, a future upward move in the loonie seems likely even if our rates stay flat and the U.S. Federal Reserve Board continues to tighten.

So what are the investment implications of these latest developments? Here are three to consider:

Good news for bonds. Bond prices have been under pressure for several months as interest rates have been pushed higher. However, the Bank of Canada’s announcement should result in renewed confidence in bonds as the threat of further hikes fades. Moreover, the May correction in the stock market should increase investor interest as the importance of portfolio diversification again comes to the fore.

Better cash yields. We’re already seeing better returns on high-interest savings accounts, with some small credit unions offering rates as high as 3.85 per cent. Returns on money market funds have lagged, but that is normal. As Treasury bills and short-term commercial notes mature, they will be rolled over at higher rates and money fund returns will rise. However, that process will only continue for another six months or so if the Bank of Canada stays on the sidelines.

Dangers for U.S. stocks. The U.S. stock market continues to offer the widest diversity in the world but a continued decline in the greenback will erode any gains for foreign investors, as Canadians have seen in recent years. To overcome this, focus on stocks with above-average growth potential and those that derive a significant percentage of their income from non-U.S. sources, such as pharmaceutical giant Johnson & Johnson. Another possibility is to use ADRs that trade in New York to invest directly in major European and Japanese companies.

Mutual fund investors can eliminate currency risk from the equation by selecting the new currency-neutral funds being offered by Dynamic, Mackenzie Financial and other companies. These provide an opportunity to invest in U.S. stocks while using hedges to reduce or eliminate the currency risk. For example, the Dynamic Power American Growth Fund, which is not hedged, gained 6.6 per cent over the six months to April 30. However, the companion Dynamic Power American Currency Neutral Fund, which is essentially the same fund with currency hedging added, gained slightly more than 10 per cent during the same period in Canadian dollar terms. Just remember, this is a two-edged sword. If the loonie should drop in value, the currency-neutral funds will look sickly compared to their unhedged stablemates.

This article originally appeared in the Internet Wealth Builder, a weekly e-mail newsletter that provides timely financial advice from some of Canada’s top money experts. For more information about becoming an Internet Wealth Builder member, go to http://www.buildingwealth.ca/promotion/50plusproducts.htm