Rates hold the key

For the past couple of years, interest rates have not been a major factor in investment decisions. Central banks around the world pushed them to historic lows in an effort to stave off a total financial and economic collapse and, for the most part, they have remained at those levels.

This will be the year when everything changes. Already a few countries, led by Australia, have started the process of moving rates higher. China has sent tremors through financial markets by tightening lending regulations to cool that country’s overheating economy.

Make no mistake: there is more news of this type coming. As the global economy recovers, central banks are going to begin to move away from the current low rate environment. That will have an effect on bond prices, the stock market, consumer credit, house sales, corporate financing, and just about anything else you can think of that is associated with money.

The magnitude of the impact will depend in large part on the pace at which the central banks move. Bank of Canada Governor Mark Carney is on record as saying that the target overnight rate will remain at 0.25 per cent until the end of the second quarter barring a dramatic shift in the economic climate. After that, nothing is certain.

The first rate-setting after June 30 will take place on July 20 with the next one due on September 8. In an interest rate forecast released earlier this month, RBC Capital Markets predicted we will see the overnight rate at 0.75 per cent by the end of September, an increase of 50 basis points (bp). Unless inflation emerges as a serious concern in the interim the Bank will probably choose to implement two quarter-point hikes to ease the shock to the financial system — assuming the RBC forecast is on target.

By the end of 2010, RBC predicts the target overnight rate will be at 1.25 per cent, which implies another 50 bp increase in the fourth quarter. Of course, that would mean that interest rates across the board would rise on everything from Treasury bill yields to mortgage rates.

The real shocker in the RBC forecast was the prediction for 2011. They expect to see very aggressive rate increases in the first half of the year for both Canada and the U.S. RBC predicts hikes of 75 bp in Canada in both the first and second quarters of the year followed by an increase of 50 bp in the third quarter and 25 bp in the fourth quarter. By year-end 2011, the forecast is for the target overnight rate to be at 3.5 per cent. That would imply a Prime Rate of 5.5 per cent, double the current rate of 2.25 per cent. The last time Prime was that high was in the first quarter of 2008.

The RBC forecast for the U.S. is intriguing in the light of the company’s predictions for Canada. They think the Federal Reserve Board will move much more slowly than the Bank of Canada, with the fed funds rate only reaching 0.75 per cent by the end of 2010. That would mean a difference of 50 bp between the Canadian and U.S. rates, which would almost certainly put more upward pressure on the loonie.

In 2011, RBC sees the Fed becoming much more aggressive with hikes of 50 bp in the first quarter, 75 bp in the second, 50 bp in the third, and another 75 bp in the fourth. By year-end 2011, RBC sees the fed funds rate at 3.25 per cent, which would be a quarter-point lower than the Bank of Canada.

There are numerous implications for investors and consumers in a rising interest rate scenario, regardless of how the numbers actually work out. They include:

1. Avoid locking in for the long-term. Many people will be making deposits to Tax-Free Savings Accounts (TFSAs) and RRSPs this month. Do not, under any circumstances, put money into GICs with maturities any longer than one year. GIC rates a year from now will likely be at least half a point to a full point more than you’ll get today. Two years down the road, you could be looking at rates that are two percentage points or more above those currently offered.

2. Avoid long-term bonds, particularly government issues. They will decline in price as interest rates rise. The one possible exception is real return bonds, which should perform well if inflation does ramp up to the 2 per cent range or beyond.

3. Be prepared for stock market volatility as interest rates start to move higher. As yields rise on lower-risk securities such as bonds and GICs, they will become more attractive to conservative investors.

4. Mortgage rates are likely to rise in 2010 and the upward momentum will escalate in 2011 if the RBC forecasts are anywhere near correct. Homeowners who are stretched thin financially should consider locking in at today’s rates.

5. Floating rate preferreds will perform well in a rising rate environment as their dividends will increase. Ask your financial advisor for recommendations.

6. If the Bank of Canada is as aggressive as RBC predicts, the loonie should be even stronger than expected. That will depress gains from U.S. stocks for Canadian investors which means we’ll need to be very selective in our choices from Wall Street.

Remember, there is no magic formula for predicting interest rate movements. The RBC forecast, like all others, is based on careful research and analysis but there are so many unknowns in the equation that we could see dramatic changes from one quarter to the next.

The only thing we can say with reasonable certainty is that rates will go higher. We need to start preparing now.

Gordon Pape’s latest book is The Ultimate TFSA Guide: Strategies for Building a Tax-Free Fortune, published by Penguin Group Canada. It can be ordered at 28 per cent off the suggested retail price here.