Cue a rate cut?

Economists and investment experts have been waiting for more than three years to see interest rates rise—the Bank of Canada’s overnight rate has held steady at 1% since September 2010—but what if everyone who’s been predicting an increase has it wrong?

People have always just assumed that rates would eventually climb. They’re already so low and with the global economy recovering, most of us would be able to handle a slow and steady rate rise. At least that’s been the thinking.

Canada’s economy, though, hasn’t been looking so hot. GDP growth has been slow, job growth has been weak, retail sales have been down and many people are carrying enormous amounts of debt. All of that is putting pressure on Bank of Canada governor Stephen Poloz to cut rates to spur economic growth.

While many people still think things would have to get a lot worse before the Bank of Canada would go through with a rate slash, Poloz has said that a cut could be in the cards.

“If the significant downside risks were to emerge, and had changed that balance of risk…then you would have to talk about the possibility of having a lower interest rate in that situation,” Poloz said to the House of Commons finance committee on April 29.

Hikes for retirees

A rate cut could be helpful for some people, such as business owners who need to borrow cash for growth or potential homebuyers who would see mortgage rates fall. Retirees, though, should hope that a cut doesn’t come.

Gareth Watson, Richardson GMP’s vice-president of investment management and research, says that what retirees need most is income. If interest rates fall, then yields on bonds will drop. It’s true that their current fixed-income portfolio will rise—bond prices climb when interest rates fall—but that only matters if they sell that bond. Most just want to collect that monthly payout.

If rates rise, then retirees could buy more fixed income with higher yields, which would be great for income seekers. That won’t be possible to do if rates go the other way. “The hope is that new issues come to market at higher rates and then retirees can get a better income stream,” he says.

A rate increase could affect their dividend-paying stocks too. With rates so low, the only way to make a decent income from the market is to buy equities with yields. Because of that, many of those stocks have been bid up in price and they’re now expensive from a valuation perspective.

If rates fall, dividend equities will get only more attractive and we’ll see even more people rush into these stocks. That will increase valuations even further, says Watson.

Rate ramifications

What does this mean for retirees? It could be harder to earn an income from both the stock and bond markets and that could have serious ramifications on people’s lives.

Say rates fall and people run into dividend-paying stocks as Waston suggests they will. The price of that dividend-paying stock will climb, which will then cause its yield to fall. (Yields drop when share prices rise.)

It’s OK if your clients are already holding that company—the price appreciation will give their portfolio a boost—but if they are jumping in with everyone else, they’ll earn less income as they’re buying in with a lower yield.

Then there are valuations. Companies that are overvalued tend to fall harder in a downturn. If rates later increase, the dividend-paying stocks your client jumped into will likely see a sudden drop.

That’s exactly what happened in the hot REIT market last summer, when long-term bonds rose in value. After the recession people jumped into this sector because yields were strong. It got so overheated that when rates rose, the S&P/TSX Capped REIT Index fell by 16.5% over about three months.

Fixed income yields, which often make up the bulk of a retired person’s portfolio, will also decline. Then what? If your client has bonds maturing, but then rates fall, the fixed income securities you would have bought with that money will now pay less than the bond that just matured.

No matter how you look at it, a rate cut will have a significant affect on a retiree’s income portfolio.

Unfortunately, there’s not a whole lot people can do because no one knows which way things will go. A retiree could buy undervalued dividend-paying stocks—there are many out there—which are good in both a rising and falling interest rate environment.

It’s also wise to stick with shorter-term maturity dates, so you can adjust your income mix faster than if you were locked into a 10-year bond.

The biggest danger, though, is the panic that comes with uncertainty or with a sudden reversal of expectations, says Waston, which is why the best idea is to stay the course.

Even if you do nothing, it’s still important to know what’s happening. If rates drop, that would be a sign that our economy is in trouble and the loonie would certainly fall further, says Watson.

He would be surprised if rates actually fell, but if he’s learned anything from the recession it’s that it’s impossible to know what will happen next.

“So much has changed,” Watson says. “People expected Canada’s rates to move higher before America’s and now people are saying the opposite. We don’t know what will happen so, at this point, maintain the status quo.”