The escalating trade war between Canada and the U.S. was the headline story last week. That’s not surprising. U.S. President Donald Trump seems determined to grind down our economy and make Canada subservient to the United States. Our country is faced with an existential threat, and Prime Minister Mark Carney has no choice but to respond forcefully.
It’s a big story for Canadians and may have contributed to the drop in the TSX last week. But New York was paying more attention to something else: rising interest rates, sparked by oil prices that are now in the US$100 a barrel range.
The European Central Bank raised its target rate by a quarter point on Thursday. The Bank of Canada and the Federal Reserve Board are holding steady so far. But the bond market is doing its own thing and that has many people worried.
The reality is that the interest rate holiday we’ve enjoyed since the Great Recession is over. Long rates are rising quickly, bringing with them growing inflation fears.
Rates were scaled back dramatically to help stabilize the global economy during the financial crisis of 2007-2009. It worked, barely, but then came COVID. The global shutdown of 2020-21 forced central banks to drop rates to near zero (and in some cases to negative levels) once again.
COVID also forced governments to make massive spending commitments to bail out businesses and individuals whose incomes were reduced or wiped out. That high level of spending has continued even though the pandemic is well behind us. The U.S. government is now facing interest costs that are equivalent to 3.3 per cent of the country’s GDP.
A look at a chart of 30-year rates on sovereign bonds reveals that Japan, which has long been a low-rate country, was paying 0.16 per cent in late 2019. Those bonds are now yielding just over 4 per cent according to data from Bloomberg.
Even though the Bank of Canada and the U.S. Federal Reserve Board have yet to move from neutral to hawkish, the bond markets are doing it for them. This is having an impact on long-term mortgage rates, credit card rates, car sales and leases, and more.
The Bank of Canada stood pat at this month’s rate review, citing a broadening economic recovery.
“However, the upside risks to inflation have increased, while new tariffs make growth prospects more uncertain,” the Bank said in a statement. “Governing Council will assess the sustainability of the economic rebound and the outlook for inflation and is prepared to adjust monetary policy as needed. The Bank remains committed to maintaining Canadians’ confidence in price stability through this period of global upheaval.”
New Federal Reserve Chair Kevin Warsh has also warned that U.S. rates may have to rise. Speaking at the August Jackson Hole symposium, he said that stubborn inflation could force the central bank to raise interest rates in the coming months. If that happens, it could set off a vicious political battle in the U.S. Mr. Trump and his administration have been urging the Fed to lower rates, and Warsh was appointed to Fed Chair earlier this year with the expectation he would do just that. If he turns around and bumps the target rate higher ahead of the mid-term elections in early November, Mr. Trump’s wrath will shake the country and endanger the Fed’s political independence.
Meantime, Mr. Trump’s tariffs and the high price of oil will continue to feed the inflation fears driving up long rates and the probability is growing that the next move in North American interest rates is likely to be up. That would have a negative effect on the prices of long-term bonds and bond exchange-traded funds, as well as interest-sensitive stocks like utilities, real estate investment trusts and heavily leveraged companies.
Banks could swing either way. Higher rates can improve their bottom lines by increasing the spread (net interest margin) between what they can charge borrowers and what they must pay to depositors. But if higher rates lead to decreased business activity and lower borrowing, the impact on bank bottom lines would be negative.
And all this is happening in September and October, historically the two worst months of the year for equities.
In this climate, investors should consider reducing their exposure to high-volatility stocks and take some profits. Focus on lower risk securities instead. A reduced return is better than riding a market plunge.
The safest investments in a rising interest rate environment are short-term cash-type securities. Here are some examples.
Inflation protected bonds and funds. We recommended the iShares 0-5 Year TIPS Bond Index ETF (XSTP-T) in September, 2022, at $39.44. It gained 3.08 per cent in the year to Aug. 31 and has had an average annual compound rate of return of 5.2 per cent since it was launched in July, 2021. It has never lost money in a calendar year.
Savings account ETFs. These invest in high-interest deposit accounts at major Canadian banks. If short-term interest rates rise, their monthly payout should too. Most were launched at $50, and the price rarely swings more than 10 cents on either side of that. We recommended the CI High Interest Savings ETF (CSAV-T) in August, 2023. It was up 2.1 per cent in the year to Aug. 31. CSAV is another ETF that has never lost money in a calendar year.
Money Market ETFs. As the name indicates, these invest in low-risk, short-term securities such as treasury bills. Guardian Capital offers two that are worth considering. The Guardian Ultra-Short Canadian T-Bill Fund (GCTB-T) invests in a portfolio of federal, provincial and corporate short-term bonds. It gained 2.25 per cent in the year to Aug. 31. The companion Guardian Ultra-Short U.S. T-Bill Fund (GUTB-U-T) invests entirely in U.S. government T-bills. It showed a return of 3.8 per cent in the year to Aug. 31. Both ETFs have an management expense ratio of 0.12 per cent.
Gordon Pape is editor and publisher of the Internet Wealth Builder and Income Investor newsletters.