The end of free money: Investors had better get used to the idea of rising rates Paul Vieira, Financial Post Published: Friday, January 08, 2010 Mark Blinch/Reuters
Mark Carney, the governor of the Bank of Canada, would dearly like to avoid raising rates before his U.S. counterpart for fear of further appreciation in the Canadian dollar. OTTAWA -- As usual, equity markets were ahead of the curve in terms of signalling an economic recovery. Of course, it didn't hurt that investors could tap money, virtually for free, due to historically low interest rates. The unprecedented run in markets has boosted confidence among households, and helped solidify the economy's shaky foundations.
But the improving economic outlook undoubtedly applies increasing pressure on the U.S. Federal Reserve and Bank of Canada to hike interest rates from record-low levels. Are traders and investors ready for the end of nearly free money? Thursday's surprise move by China to raise rates on short-term treasury bills shows just how touchy the subject will be for the year ahead. The move had the immediate effect of cooling down red-hot stock markets in emerging countries.
"Markets are more comfortable that a recovery is here," says Mark Chandler, fixed-income strategist at RBC Capital Markets. "The next thing now, then, is how are we going to normalize rates. We are at emergency levels, but we are no longer in an emergency situation. So it's a question now of timing and magnitude." At present, federal fund futures - which provides a gauge of market expectations for U.S. Federal Reserve interest rates - are pricing in a policy rate of 0.90% by the end of 2010, up from its current target range of 0% to 0.25%.
That means markets are expecting roughly 75 basis points to nearly a full percentage point in interest rate hikes. A similar instrument in Canada pegs the Bank of Canada's overnight rate to rise 100 basis points, to 1.25%, in the same timeframe. Mr. Chandler adds the biggest debate in financial markets is the size of the first rate hike, from either the Fed or the Bank of Canada. "When there's all these messy [liquidity] programs out there, and [the central bank] is not really moving for pure inflation reasons, then we are not sure the normal guideposts hold. So it will be a top-of-mind issue for financial markets."
Views on the timing and magnitude of rate hikes are all over the map. Complicating matters is the recession just passed was like no other, prompted by the near collapse of the Western world's financial sector. Central banks might err in keeping rates too low for too long to stoke private-sector demand.
Meanwhile, in Canada, Mark Carney, the governor of the Bank of Canada, would dearly like to avoid raising rates before his U.S. counterpart for fear of further appreciation in the Canadian dollar. Still, investors had better get used to the idea of rising rates, just as they should understand that the great global stock market rebound - with the Toronto index up roughly 56% from lows last March - can't carry on forever. As a starting point, findings from a CIBC World Markets analysis suggest every 100-basis-point increase in the central bank's overnight rate knocks stock valuations down by roughly 5%.
"Now is not the time for Canadians to become complacent," says Andrew Pyle, wealth advisor and markets commentator at ScotiaMcLeod. "If we are entering a different phase where rates are heading higher, which I believe, then that means we are not going to see a repeat of last year's rally."
Prior to this recession, the prevailing wisdom was that central banks commence policy tightening roughly six months after the unemployment rate peaks. Recent job data in Canada indicate the labour market has indeed stabilized, and there are signs of a turnaround in the United States - even though payroll data for December, released yesterday, fell short of market expectations. Economists at BMO Capital Markets said in a recent note they expect U.S. unemployment to peak this quarter, and have tentatively penciled in a rate hike from the Fed in September.
As for Canada, they forecast the Bank of Canada to begin tightening in July, once its conditional pledge to keep rates at 0.25% ends. Others differ. Perhaps the most controversial call of all comes from analysts at Goldman Sachs, who believe the Fed will not raise interest rates for two years.
David Rosenberg, chief economist and strategist at Gluskin Sheff + Associates, said the first few rate hikes following an easing period generally have little impact on the immediate direction of equity markets. The bigger impact comes during the final rate hikes in a tightening stage because they tend, more often than not, to push an economy into a tailspin. Perhaps the most stunning example was in 1937-38, when Fed moves to withdraw stimulus pushed the U.S. economy back into a deep tailspin and sent markets reeling. There's little concern Ben Bernanke, the U.S. Fed chairman who is a student of the Great Depression, would allow history to repeat itself and tighten too soon. The same goes for Mr. Carney.
Peter Buchanan, senior economist at CIBC World Markets, believes central-bank tightening will not begin until into 2011. Regardless of when the tightening starts, he says the initial impact should be negligible for publicly-traded Canadian companies. "We are starting from fairly low rates at this point in time, but one thing to bear in mind is that Canadian corporate balance sheets are in good shape. Debt-to-equity levels are quite low and that means if rates go up, that won't be a lot of stress on companies from a financial standpoint," Mr. Buchanan says.
In a report he recently co-authored, he indicated there's little risk that dividend-paying companies - which tend to be highly exposed to interest-rate movements - would scale back dividend payments in the event of tightening. "If anything, this past recession saw a milder rise in the TSX payout ratio than what we've seen in past economic downturns," the report says. It adds firms are paying out only 40% of consensus 2010 operating earnings in dividends - a smaller amount compared to the previous downturns in the early 1990s and 2000s. That provides some assurance that dividend-paying issuers won't be caught in a trap once borrowing costs rise.
David Baskin, president of Baskin Financial Services in Toronto, says dividend-paying stocks, including REITs, still "have some catch up to do," as they have yet to advance at the same pace as other asset classes during the recent rally. The TSX composite index has climbed 56% from its low last March. In comparison, the exchange's utilities and telecom subindexes have risen roughly 26% and 15%, respectively, during the same time period. "As more and more clients come up out from their nuclear bomb shelters, they see that GICs and Canada Savings Bonds look unattractive - while old-fashioned utilities look good," Mr. Baskin says.
As for asset classes to avoid in an era of pending rate hikes, money managers and advisors appear universal in their dislike of longer-term fixed income. "I would be very, very hesitant to hold long-term fixed income products in this market. We would find that very scary," said Michael Sprung, president of Sprung & Co. Investment Counsel in Toronto. "The fear is that when interest rates rise, the prices for long-fixed instruments will fall precipitously." Mr. Sprung, who believes there's a risk of a double-dip recession, said once interest rates begin to rise, "people are going to start to worry about the stamina of this recovery. And that could cause commodity prices to come off a little bit, which would be reflected in the TSX."
Still, there are those, such as Mr. Pyle, who indicate market participants are prepared for central bank tightening - and would welcome the development. "They are ready to engage that question now, and some market participants would be ready if it meant protecting against even higher interest rates down the road by putting a cap on where long-term borrowing rates and mortgages will go," he says. Long-term interest rates - for funding of more than five years - have returned to somewhat normal levels. Last week the yield on the U.S. 10-year Treasury note rose to 3.9%, its highest level since early June. After the jobs numbers yesterday they closed at 3.83%. A Bank of America-Merrill Lynch report warned this week that 10-year yields above 5% could prove "destabilizing" for the markets. What could push such a move are concerns of uncontrolled government spending. "We are starting to price in supply risk and inflation risk," Mr. Pyle. "If that's not arrested any time soon, then those long-term rates will continue to rise and that becomes a risk for the equity markets, as debt-servicing costs for businesses and households go up."
