WEALTH Matters — sUMMER 2012

INTEREST RATE TRENDS

One-year and five-year GIC rates fell back in the second quarter of 2012 to their September 2011 levels, reflecting expectations of continued low inflation in an environment of weak global economic growth. Terms from 2 to 4 years held steady at their March levels.

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The Case for Equities

Interest Rate Trends

Investment Market Commentary

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The European Central Bank announced at the very end of June that it will now directly inject capital into any European country bank that becomes insolvent, so that such capital requirements will no longer add to the debt of  the bank’s host country government. This should reduce the risk that yields on bonds of weaker Eurozone countries could spike to unsustainable levels, and that a ‘contagion’ of bad debts could impact the solvency of healthy banks.

Unable to raise rates because of continued low rates globally, the Bank of Canada continues to be concerned about over-stimulating consumer borrowing to unsustainable levels, especially given the large increases in home prices over the past several years no doubt caused partly by cheap loan rates. The Bank has resumed warning consumers to kept their debt burdens low enough to carry once rates do rise. The regulator of banking, the Office of the Superintendent of Financial Institutions (OSFI), is again limiting credit growth using rule changes. In April, OSFI announced that the maximum CMHC insured mortgage would reduce to 80% from 85%, and revolving lines of credit would be limited to 65% of the value of the property it is secured against (down from 80% which has been the standard for many years. The mortgage change takes effect   in July and the line of credit change takes effect next year, though major banks are expected to react by year-end.

 We still don’t expect the Bank of Canada to make any increases to the bank rate until near the end of 2012, and possibly not until mid 2013, mainly depending on what happens in the US.

The yellow line in the graph is bond yield reduced by 40% to reflect the impact of income taxes on bond interest. Note that the yellow line more closely matches the red inflation line. Rational investors expect the after-tax value of their investments to grow by at least the inflation rate. Otherwise they would be better off to buy more goods now rather than invest their money.

Another conclusion we can draw is that after taxes, GICs and government bonds generally do not allow investors to grow their purchasing power: they can merely avoid losing purchasing value to the effects of inflation.

Generally, to achieve growth in real value, investors must turn to equity investments such as stocks and real estate (which are more volatile), and use their bonds and GICs to stabilize their portfolios. Please read our article The Case for Equities for more perspective on this.

Inflation Expectations Drive Interest Rates

The graph below compares the yield on 3– to 5-year government of Canada bonds (blue) with the ‘All Items’ inflation rates (red) as published by Statistics Canada. It is clear that bond yields generally rise and fall with inflation rates. The correlation is not precise because the bond market adjusts prices (and yields) based on expected future inflation not on measured past inflation, and because other factors also influence bond yields.

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