Interest Rates Are Dropping – Now What?

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On Wednesday, Canada’s central bank officially ended the fastest and most dramatic interest rate-hiking cycle in our country’s history by dropping the benchmark interest rate by 0.25%. This brings our overnight lending rate from 5% to 4.75%, and our central bank governor Tiff Macklem has indicated that more rate drops are on their way.

This news has been heralded by our media as welcome relief for everyone that’s been punished by high rates, meaning mortgage holders, but that relief is not going to be as dramatic as many hoped.

The reason? Here’s Canada’s historical interest rate chart.

Mortgages in Canada renew on 5 year terms, so everybody who’s renewing their mortgages this year had their rates set back in 2019, when the central bank rate was just 1.75%. Even though 4.75% is lower than 5%, it’s still way higher than 1.75%, so this news unfortunately won’t prevent homeowner’s mortgage payments from going up. It just won’t go up quite as much as it would have had they renewed a week ago.

For the rest of us, though, how does this news affect our portfolios, and do they warrant any changes to our investment strategy?

Standard disclaimer: These are just my personal opinions, and is meant for entertainment purposes only. My opinions are not meant to be taken as investment advice. Do your own homework, and make your own decisions.

The Housing Market Is Going To Heat Up

Market predictions are always a risky business, but I don’t need a crystal ball to see this coming. Canada’s real estate market has been in deep freeze this year as buyers have been waiting on the sidelines waiting for rates to fall and, therefore, make houses more affordable.

It won’t help as much as they hope, though. After all, if everyone is waiting for a rate drop to start buying, then the force of all this pent-up demand hitting the market at once will make prices go up, negating any relief that a lower interest rate will give.

But we don’t need to keep bashing real estate. I’ve already been doing that for years, and I’ve learned that if people are determined to screw their finances over to buy a pile of overpriced bricks, there’s nothing I can say that will dissuade them.

If you are planning on using this as an opportunity to buy, go for a variable rate mortgage rather than a fixed rate one. Even though variable rate mortgages screwed over a lot of people during the pandemic, the fact that the central bank has telegraphed that they’re going to keep cutting rates for a while, which means that your mortgage payment should drop over time as this happened.

CAD is going to get creamed

We can’t just look at Canada’s central bank policy in isolation. We also have to care about what the Americans are doing as well. And on the American side, their central bank is looking at a very different situation.

While our job creation and unemployment numbers have been underwhelming, theirs has been red-hot.

US job growth shot much higher than expected in May, jumping to 272,000, while the nation’s jobless rate rose slightly and broke a 27-month streak of below-4% unemployment.

US economy added a whopping 272,000 jobs in May: CNN

At the beginning of the year, everyone was predicting that the US central bank would be cutting rates along with everyone else. Now, with jobs consensus is that they may not cut at all this year. From the same article:

“It’s hard not to like a lot of jobs, and this report was well above what I expected, and I think just about what everyone expected,” Dean Baker, an economist who co-founded the Center for Economic and Policy Research, told CNN. “We’re seeing a lot of job growth, that’s a generally good story.”

He added: “But the Fed’s going ‘Oh, can we cut [interest rates]? Can we cut? Can we cut?’ It’s hard to look at this report and make a good case for cutting, I’ve got to say.”

So now we have a tale of two central banks. The Canadian one is under pressure to cut rates in order to bail out the housing market, while the US one is in no rush to do so. That means that the interest rates are going to start to diverge. And that means the CAD is going to get weaker relative to USD.

For Canadian investors, that means that we should make sure that any foreign ETFs are ­not currency hedged. Remember that currency hedging is a strategy that removes the fluctuations of the underlying currency from the performance of the fund. This is good if you’re buying an ETF that invests in a foreign currency (like, say, USD), and then that foreign currency gets weaker vs. your home currency. However, if the opposite happens and the USD gets stronger against the CAD, then being in a currency unhedged fund will actually work out in your favour and add a tailwind to our performance.

The two asset classes in our portfolio that have foreign exposure are the US and International MSCI EAFE Index. Even though ETFs like VUN and XEF are traded on the Canadian stock market, their underlying assets are denominated in USD, so we want to make sure that neither is using currency hedging. These particular ETFs (and the other ones we mention in the Investment Workshop) all don’t use currency hedging, so if you’ve been investing according to our workshop, you should be fine.

Bond Yield Curve Should Start To Normalize

Finally, let’s talk about bond yields. The Canadian bond yield curve has been deeply inverted all year. Here’s the most recent readout.

The media often cites an inverted yield curve as a predictor of recessions, but it would be more accurate to say that an inverted yield curve is a sign that bond traders are anticipating interest rates will come down. Usually, recessions are what causes this, which is where the confusion comes from, but those events aren’t always linked. It’s entirely possible for interest rates to come down without a recession, which is what’s happening now.

This inverted yield curve is why we moved off the bond index for the fixed income portion of our portfolio last year. Why would we want a bond index paying 3.5% when I can get a much better deal elsewhere?

But this situation should be coming to an end soon. Inverted yield curves exist when the market is anticipating interest rate cuts, and now that those cuts are here, the bond market should start to normalize.

For the record, I don’t know when this will happen, or how long it will take. I just know it has to happen eventually. Inverted yield curves don’t make sense under normal conditions, because it doesn’t make sense for a 25Y bond to be paying less interest than a savings account. So we know that eventually, this shape…

Will eventually have to turn into this shape…

How this happens is subject to some debate, but here’s my read on the situation. The are only two ways that yield curves “untwist” themselves.

The first is if the short end of the yield curve drops below the rest of the curve, like this…

This is the one everyone seems to be hoping for, as it means that bond traders will see their bond holdings appreciate in value, and fixed-rate mortgages, which are set by the 5Y bond yield, will either stay steady, or come down.

My issue with this scenario is that the yield curve is so steeply inverted that it requires interest rates to move down a lot in order for it to normalize itself. Just by eyeballing the current yield curve, this would require a drop of more than 1.5%, and as much as mortgage holders would love for that to happen, there’s a big obstacle to that and it’s the CAD-USD exchange rate.

Canada’s interest rates can’t drift too far from the US because if the CAD gets too weak against the USD, all that stuff we import from the Americans like, say, food, become more expensive. More expensive food makes inflation go up, and if inflation starts going up again, that will put a brake on further rate cuts. This scenario might have made sense when the US was widely expected to drop rates at approximately the same time as Canada, but now? I just don’t see it.

The other way that the yield curve normalizes is that bond traders get sick of earning so little interest and start selling.

As bond prices drop, bond yields go up, like so…

In this scenario, bond prices fall to a level where the yield curve seems reasonable again, at which point value investors swoop in and stabilize the price.

This is the reason why I’m keeping my fixed income allocation out of the bond market for now. I think we’re more likely to go into the second scenario than the first, and if that happens that means there’s a sell-off coming.

I could be wrong. I don’t have a crystal ball after all. But because my fixed income is locked in at a yield of 6% with preferred shares, I don’t really see a compelling reason to take a pay cut by returning back to bonds. At least, until their yields look more reasonable.

My plan is to stay put, get paid my 6%, and wait for an opportunity to get back in.

Conclusion

What a ride this market cycle has been. A once-in-a-lifetime pandemic, followed by interest rates dropping to zero, followed by sky-high inflation, followed by the sharpest interest rate spike in history. These past few years have really seen it all.

Fortunately, this weirdness appears to be coming to an end, and a return to a more normal interest rate environment is around the corner. How are you planning to navigate the coming months? Let’s hear it in the comments below!


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10 thoughts on “Interest Rates Are Dropping – Now What?”

  1. Thank you for sharing! Super insightful and lets a lot to dig more into.
    ps. I don’t if you’re aware but there are 9 full width ads in the article + banner ads + lower popup ads. It made it confusing to understand what is your content VS the ads that try to match your content. Not sure if you changed anything recently?
    Keep it up!

    1. do you not like free, incredibly informative content? i am grateful for blogs like this, as 99% of most other blogs are trash. this one happens to be life changing. i’ll support and take the ads any day.

  2. For me, nothing changes.

    I stay 100% Equity and I am now taking advantage of the FHSA account as well!

    I (happily) sold all my Bonds (ETFs and Mutual Funds) during the brief market crash in early 2020 and bought Equities on sale around that time.

  3. My family moved to BC from the southwestern US for the past two years, and we love where we are — everything about it, really. Now we have to start talking about whether to go back to the US or not. Can someone explain what happens when a family who mortgaged a house in Canada at 1% is expected to suddenly pay 4%+ five years later? What if their income hasn’t come up? Do they just lose the house? This 5-year-max thing is very confusing for me.

    1. Hi Tom,

      The first thing would be not to panic; there are options that both your bank or, even better, a mortgage broker should be able to help with.

      Some things to look into:
      5 years isn’t the max, it’s most common though. You could choose to pay a little more and lock in for 7 or even 10 years.

      Normally, we’re not talking about a sudden jump from 1% (which is an incredibly rare rate) to 4 or 5%; people either have variable rates and see the payment slowly rise (and then fall) or they are seeing rates rise over a couple of years, knowing their renewal is coming. That gives some time to prepare.

      Keeping in mind that the bank should be approving you for a mortgage at a higher rate than you actually pay, most people *should* be able to afford more normal interest rates. We’re living through a bit of an extreme case though.

      I think what most people will be doing if they can’t manage the current interest rates when they renew is to look at extending their amortization back to 25 or even 30 years.

      That’s not ideal, but it should enable people to keep their homes while waiting for rates to drop again. Just don’t expect to see 1% again.

  4. I believe you are making a mistake. Holding ZPR now that the Bank of Canada has dropped 0.25% is risky. It is very possible that the BoC will continue to drop rates further over the next 6 months to a year. The ECB dropped rates the day after the BoC rate drop announcement. PMI in the US is dropping as well.

    You may think bonds are trash however there is a time and place for them. In Canada, that time and place started in May 2024. The time to cut loose of ZPR was the same time.

    I understand you want those tax efficient dividends from ZPR. It’s just I don’t keep ETFs in my portfolio just to collect a dividend. If ZPR heavily losses capital value, that dividend will not be worth collecting.

    I’d rather pay more income tax temporarily collecting interest from a bond that may enjoy tax efficient capital growth than watch the value of my investment portfolio drop unnecessarily.

    To each their own. All the best on your investment strategy.

    1. It is all about timing the market.

      As their records show, Wanderer and Firecracker have been very good at that.

      I bet they already have cut their ZPR holdings as of today.

        1. Yes and no. While I agree you should stay invested, what you invest in is equally if not more so important. Something like ZPR is a situational investment. Good at certain times. Very, very bad at other times.

          If you buy and hold and do nothing else (including rebalancing your portfolio), you are shooting yourself in the foot. Ultimately, rebalancing is timing the market as well. Nobody scoffs at rebalancing. There’s nothing to be ashamed of regarding market timing. It’s just most people are bad at it.

          You just don’t fully understand what an ETF like ZPR actually is and how current events move it.

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