How Does the Lower Bank of Canada Policy Rate Affect Me?
It was a typical Saturday morning at the local diner, where Lee, John, Dave, and Bob gathered for their usual breakfast and discussion about investments and the economy. This weekend, the hot topic was the recent decision by the Bank of Canada to reduce the policy rate from 5% to 4.75%.
Lee: The Cash Enthusiast
“Well, guys, what do you think about the rate cut?” Lee asked, stirring his coffee. When interest rates started going up dramatically a couple of years ago, Lee began to put a lot more of his money into Investment Savings Accounts (ISAs) and Guaranteed Investment Certificates (GICs). Both his fixed-income and equity ETFs had lost a lot of value in 2022 and with the high interest rates that cash-equivalent deposit products were producing, he had been content to leave relatively little of his money in bonds or stocks, prioritizing safety and liquidity.
Bob looked up from his newspaper. “For you, Lee, it means the interest rates on your ISAs will likely go down. You might see lower returns on your investment portfolio.”
Lee sighed. “I figured as much. Nothing seems to last forever. My returns have been rock-solid by using ISAs and GICs, but they don’t compare to the returns I’ve had from my equity ETFs last year and this year, so far. In that sense, I suppose I’m losing some ground, although I’m doing better than inflation so I don’t really need to worry yet. But ISAs give me peace of mind. And my tried-and-true laddered GIC strategy is doing exactly what I wanted. Do you think I should put more back into equity and fixed-income ETFs?
John chimed in, “Diversifying a bit might not hurt, Lee. Even just a small shift into bonds or equities could help balance out the expected lower returns from your ISAs.”
“I like the good returns I am getting from my GICs, too. As you know, I think a 5-year ladder is the best way to invest when it comes to GICs. I added a lot of money to them over the last couple of years because of the high rates I was able to get, especially for the 1 and 2-year terms. What do you think is going to happen to them?” asked Lee.
Dave’s response was heartening, at first. “You are going to be happy about all the GICs you have that are not maturing for another 2 to 5 years. You’ve got good rates now. But, because you are going to have GICs maturing, if you decide to renew them you are probably going to get a lower rate. Frankly, and this is not just because I’m a bond guy, I think you should consider bond ETFs.
“Okay,” Lee said, “I need to be prepared for lower returns. But, why?”
“You have probably heard something like, ‘When the government introduces a change, the company passes it on to their customers,’” replied Dave. “The same goes for the Bank of Canada and the banks. If the policy rate gets lowered, the banks lower their interest rates. This should help borrowers, which will help stimulate the economy – the whole point of lower interest rates – but it also means that lenders, which is what you are when you deposit money into an ISA or buy a GIC, get paid less. Banks don’t want to borrow from their depositors at higher rates than necessary.”
“That makes sense, although I never thought of myself as someone who lends money to my bank,” Lee responded. “I’ll have to think about what to do. The rate hasn’t moved much yet.”
John: The “American” Investor
John, who has a penchant for investing in US securities and closely watches the exchange rate between the Canadian dollar (CAD) and the US dollar (USD), was quick to point out the currency implications. “With the Canadian dollar weakening due to the rate cut, my US investments will yield higher returns in Canadian dollar terms. Woo-hoo!”
Dave nodded. “True, John. You might see better returns now, but if the exchange rate shifts again, it could go the other way. Have you considered any hedging strategies?”
John shrugged. “I’ve thought about it, but it complicates things and the higher MER that comes with hedged ETFs outweighs the benefit in my opinion. Besides, when the Canadian dollar is going down, this is not the time to hedge!”
“John, you’re all excited about interest rates,” interjected Bob, “but have you considered that it might not make much of a difference if oil prices stay high?” John frowned. “Have you never heard that the Canadian dollar is considered a ‘petro-currency’? Sure, lower interest rates in Canada will tend to decrease the value of our dollar, but whether we like it or not, we’re a major producer of oil, which is priced in US dollars. If demand for Canadian petroleum products continues to stay high, that will mitigate the impact of lower interest rates. Our dollar might even go higher!”
“Bob, you sure do like to complicate things,” sighed John. “But still, the US markets are bigger than the rest of the world’s equity markets combined. And emphasizing the US has worked very well for me over the last decade. I need to think about this some more.”
Dave: The Bond and Economic Impact Watcher
Dave, always concerned about bonds and the larger economic picture, leaned forward. “Speaking of which, this rate cut could actually benefit my bond investments. Lower yields on new bonds could increase the value of my existing ones with higher rates.”
“Well hang on there just a sec, Dave,” objected Lee. “A moment ago, you said lower interest rates will hurt my GICs when I have to renew them. I think of GICs as a bond substitute. Why will bonds do better and GICs do worse?”
Dave smiled. “Lee, I think you know this as well as me, but you’ve ignored bonds for so long – and probably for good reason – that you’ve probably forgotten about the basics of bonds.
“In 2022, when both bonds and stocks lost value, it was because of inflation. We had low interest rates for a really long time, so existing bonds that were paying out at 2% suddenly weren’t worth much anymore. To get anyone to buy those bonds meant that a bondholder had to offer a deep discount on the price. However, new bonds that were issued in the last couple of years had to offer ‘coupon’ rates that were in keeping with market expectations.
“Now, with interest rates beginning to drop again, the discount on bonds that were issued more than two years ago will become less severe, and bonds that were issued within the last two years are likely going to sell for a premium if the Bank of Canada rate continues to decline. And if you sell a bond at a premium, do you know what that means? Capital gains, which have only half the tax bite that interest income does.”
Lee looked rueful. “Yeah, that sounds vaguely familiar. I guess this whole rate-cutting thing has only just begun so I have time, I suppose. Maybe when one of my GICs matures next month, I’ll take half the proceeds and put it into a bond ETF.”
Bob smiled. “And it reflects an effort to stimulate the economy. If the lower interest rate does what it’s supposed to do, it will lead to lower borrowing costs which should encourage spending and investment. But, Dave, you need to watch out for potential inflation down the line.”
Dave agreed. “That’s exactly the point, isn’t it? All of us need to have balanced portfolios of some sort, especially as we ‘enter our dotage.’ I like to think I have enough in equities but I’m going to redo one of those investor questionnaires to see what it says. Not that those online tools are perfect, but they have some value at least.”
“Hey!” John protested. “Who are you calling old, Dave? I’ve got a long way to go before I enter my ‘dotage.’ Otherwise, I agree with you.” John smiled with a confident glint in his eyes. “But don’t put too much of your equities in Canada. After all, our markets make up only about 3% of the world’s securities.”
Lee, Dave, and Bob rolled their eyes as John once again found an opportunity to imply that US markets are the way to go.
Bob: The Equity Investor with a Historical Perspective
Bob, the oldest of the group and a firm believer in taking a long-term view, had emphasized equity investments over the years. “Lower interest rates generally benefit equities. Companies can borrow more cheaply, which allows them to invest more in their business and boost profits. I’m confident that the value of my portfolio will grow as a result.
Lee looked intrigued. “So, Bob, you’re sticking to your strategy then? What about the fact that a lower dollar will make imports more costly? Canadian companies may find their costs driven up as a result.”
Bob nodded. “Absolutely. I’ve seen interest rate changes come and go. The key is to stay focused on the fundamentals, stick to your long-term asset allocation, and not get swayed by short-term fluctuations in the markets.”
Broader Implications
The conversation shifted to the broader implications of the policy rate cut. Bob, ever the historian, remarked, “Remember, guys, this isn’t the first time we’ve seen rate cuts. It’s part of the economic cycle.”
John, still pondering his US investments, asked, “But what about the Canadian dollar? If it keeps weakening, how will that affect us all?”
Dave responded, “A weaker Canadian dollar can make our exports more competitive but also raises the cost of imports. It’s a balancing act. For investors like us, it means staying vigilant and possibly adjusting our strategies to mitigate risks. That doesn’t mean we should tweak our portfolios every month. Instead, at least in my view, we should settle on an asset allocation that we can live with for the long term and just rebalance once a year or so. As William Bernstein said, ‘Investing is like soap. The more you handle it, the less you’ll have.’ In other words, get your asset allocation right and then just leave your portfolio alone.”
Lee, looking thoughtful, added, “I guess this means I really should consider diversifying a bit more. Maybe adding some more money to my bond and equity ETFs, like you guys have been suggesting.”
Bob smiled. “That’s the spirit, Lee. A well-rounded portfolio can help you manage these changes.”
Walking home from their breakfast, Lee reflected on the morning’s conversation. The rate cut from 5% to 4.75% by the Bank of Canada, although only quite minor at this point, had different implications for each of them, especially if the cuts continue, but the shared wisdom and perspectives provided some helpful insights. Lee decided it was time to review his investment strategy.
For John, Dave, and Bob, the breakfast reinforced the importance of staying informed and being adaptable, even as they held firm convictions about their investment priorities. They knew that maintaining a diversified portfolio in the context of a larger financial plan would always be key to navigating the ever-changing financial landscape.
This is the 250th blog post for Russ Writes, first published on 2024-06-10
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