Falling rates: the effects on your portfolio!

Ashleay: Hello and welcome to the "In Your Interest!" podcast. My name is Ashleay and this week, we're talking about one of the hot topics of the day with Alex Lamontagne, Director, Insurance Individual Savings and Retirement Products at iA Financial Group, and Sébastien McMahon, Chief Strategist. Hello Alex! Hi Sébastien!

Alex : Hi Ashleay

Sébastien: Hi Alex. Hello Ashleay! Great to be here!

Ashleay: Yeah! It is great to be here. Alex, we're going to have plenty of questions for you, and for you, too, Sébastien! Let’s get right into it. On Wednesday June 5, we had our first cut to the key interest rate after a series of hikes that began in 2022. Further cuts are expected in the coming months, which could have a significant impact on people's savings. Meaning there’s good reason to stay on top of things and seize this opportunity to grow your savings. Let's get started! Sébastien, so that we fully understand what's ahead, can you tell us about the relationship between the economic cycle, inflation and the interest rate?

Sébastien: Sure! I would say that this is all about the economic cycle. There are four phases in the economic cycle. We’re now in the fourth phase. But let's start from the beginning: the first phase is when the economy is emerging from a recession; usually growth is perking up and inflation remains low. So this is the beginning of the cycle: robust growth leading to a return or a slow return of inflation. After a period of strong growth, you start to see inflation perk up and this is when central banks tend to start raising interest rates to reign inflation in a little bit. So that would be phase 2. After that, we move to phase 3, where there’s rampant high inflation and growth is slowing down. So, central banks continue to hike interest rates to control inflation, which keeps growth under control. Growth now begins to slow, which is sometimes when a recession begins. And then, you get into phase 4, where growth is low and inflation is low—and we've already discussed a few times on this podcast that Canada seems to be in a per capita recession, so we've been there: inflation has now progressed towards 2%. This is the final phase of the business cycle, and when central banks start cutting interest rates to give a breath of fresh air to the economy. Then we start all over again.

Ashleay: Right, and I believe that these cuts have an effect on the entire economy, but also on the market and each of our savings. Is that fair to say?

Sébastien: Yeah, when you look at households, you can identify three effects here. You also have some opportunities to consider with the help of your financial advisor, if you want to think about how to best position your portfolio for these effects.

Ashleay: Okay! So, let's talk about them. What's the first one?

Sébastien: Well, I think the first one is pretty obvious, which is why I'll handle it. I’ll leave the most complicated ones for Alex. The first one is a reduction in the cost of your variable rate debt. So, think about revolving debt, think about your variable mortgage rate. If the bank of Canada decides to cut rates on a Wednesday—say on Wednesday June 5—well, at the end of that day or the day after, the banks will have lowered their preferred rate and you’d see a lower rate on your mortgage. It’s very immediate. And when the markets are anticipating that the central bank will be cutting rates for a while—which is what we are seeing now: markets are anticipating three cuts by the end of this year—well, the market rates start to fall. This is a bit more technical, but the five-year market rate is now already a bit lower, which means that if you want to sign for a fixed rate mortgage right now, you’re paying about 6% on the displayed rate or the official rate, whereas it was 6.5% at the beginning of the year. So, we're seeing that breath of fresh air coming into the economy with the lower cost of credit.

Alex: And what this does for people is it puts less pressure on household expenses, creating a little bit more liquidity, especially for those who adjusted their budgets to face recent high levels of inflation. Those people really get that additional month-to-month flexibility, since they remain at the same income level, but now have less expenses. For these people, it’s really important to reassess whether their savings plan is still up to date before going off and spending this additional space in their budget. People should think about meeting with an advisor to consider investing more in savings products before spending this additional flexibility.

Sébastien: So there's an opportunity to buy more stuff or save more money.

Alex: Exactly.

Sébastien: Because you have less financial pressure, you have the opportunity to make smart decisions.

Ashleay: Right, and what would be the second one?

Alex: The second effect of lower rates is a reduction in the rates of return for guaranteed investment products, like high interest savings accounts (HISAs), guaranteed investment funds (GIFs) and guaranteed investment contracts (GICs). The rates of return on these products offered by financial institutions are directly linked to the overnight rate. For example, because it’s variable product, the decreased rate directly affects the high interest savings account. This means that the money you’ve invested would earn a lower rate of return than it did a couple weeks ago. It might be a good time to reconsider the amount of assets you have in your high interest savings account and maybe consider whether it's time to get back into the market. And if you do that—I think it was Pablo Carrera who mentioned it on the podcast a few weeks ago—you shouldn’t try to time the market and get back into it in one shot, because then you’re really depending on how the market performs in the next couple weeks. You might want to talk to your advisor about dollar cost averaging back into the market using funds from your high interest savings account (if it makes sense in your strategy to do so).

Ashleay: Okay. And what would the last effect be?

Alex: When you’re talking about changes to the interest rate you also have to talk about bond market movement. The last effect is that when rates fall, the value of bonds rises. And there may be opportunities on that front.

Sébastien: Yeah. We can do a little bond math: When rates rise, the market value of bonds falls, and vice versa. If you were invested, had a balanced portfolio and had bonds in your portfolio, you know that 2022 and 2023 were very tough years for bonds because interest rates were moving higher. This is because new bonds come onto the market with a higher interest rate, which makes older bonds less attractive, causing their prices to fall. But the reverse is also true: when monetary policy implements lower rates, you get lower market rates and a rise in the market value of your bond portfolio. It's very important to understand this. Now, when we’re at an interest rate peak—we can’t say so definitively, but we're now likely near the high—it's good to be diversified, it's good to have bonds, and now’s a good opportunity to add bonds to your portfolio, if you haven't already. You’ll also want to consider the broader picture. So, within fixed income, you don't just want Canadian government bonds or U.S. government bonds; you want to have government bonds with long maturity, short maturity, you want investment grade corporate bonds: you want diversification in your portfolio. There are many opportunities, here. If you trust your money to an active portfolio manager, they’ll position it correctly.

Alex: Yeah. And I guess I would add in all cases we talked about some opportunities, but the decision that you have to make always depends on your specific situation. So, if you were investing for a horizon of two years, I might not give you the same advice as if you were investing for 30 years. It’s best to talk to your advisors, they’re the ones who will help you make informed decisions that are suited to your needs and according to your own personal situation.

Sébastien: Right, and we do a lot of these “Investing 101” kind of episodes: diversification is a very important one, not falling for the flavour of the month, etc. And now we're seeing Central Banks, the Bank of Canada, the European Central Bank starting to cut interest rates—the Fed isn’t there yet— which is a tailwind for bond portfolios. But that doesn't mean that you should go all in on bonds, either; you need to be invested in equities, too, because when you have this breath of fresh air coming in from lower interest rates, equities benefit. That’s why it’s important to trust your money to an active portfolio manager who will position you to benefit from that and keep a well diversified profile that fits your personality and objectives.

Ashleay: Right! So, to sum up, this is just the beginning and there are opportunities to be seized right now. Looks like I've got some homework to do! Well, Alex, Sébastien, thank you for sharing. And to all our listeners, thank you for being here, we’ll see you next week with another episode of “In your interest.” Loved this podcast? Want to know more about economic news? Follow our “In Your Interest!” podcast, available on all platforms, visit the economic news page on ia.ca or follow us on social media.