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Table of Contents
Put your financial adviser on a leash
February 11, 2000
100% Foreign content for your RSP
December 22, 1999
Tax Loss Selling or Dealing With Your Mistakes
November 26, 1999
Life Stages of your RRSPs
November 12, 1999
Just give me boring (but great) rates of return
November 3, 1999
De-mystifying Demutualization - part Two
October 25, 1999
De-mystifying Demutualization - part One
October 19, 1999
Seg funds for the simple minded
September 14, 1999
The interest rate game Part 2
August 12, 1999
The interest rate game Part 1
July 30, 1999
Choosing funds: Five for the long run
July 14, 1999
New Funds: To buy or not to buy
July 2, 1999
Making sense of momentum investing
June 18, 1999
Rating the fund managers
June 4, 1999
Resource recovery hinges on supply and demand
April 30, 1999
Tech funds draw strength from favourable trends
March 24, 1999
Withdrawing from your RRSP
March 9, 1999
The economic implications of the euro - An interview with Ranga Chand
February 12, 1999
Underperforming small-cap funds have strong upside potential
January 29, 1999
How to pick a winning equity fund portfolio
January 15, 1999
View the Weekly Insight archive
   

The Interest Rate Game: Part One

RICHARD WEBB AND LEVI FOLK
Friday, July 30, 1999

There are many things that active and hands-on equity fund investors keep an eye on, other than the market value of their investments. These are things like stock market levels, momentum, stock valuations, growth and value strategies, earnings and fund performance records. However, how many investors, , know about the value of keeping careful watch on interest rate movements and trends? Isnít this the kind of thing which bond fund holders usually look at?

Maintaining an interest rate watch is standard modus operandi for bond fund investors, but equity fund investors can benefit a great deal watching them as well. Interest rate movements can affect equity funds as well as bonds, and the lessons gained from the study of monetary policy can be applied to equity fund investing with great effect. This article does not intend to be a definitive guide to monetary policy and economics, but rather it is a small primer on how equity fund investors can get an understanding of the effects of interest rate changes and better protect their portfolios.

First, letís cover the basics:

  • The U.S. Federal Reserve Board and the Bank of Canada set monetary policy by either raising or lowering short-term interest rates. The primary reason is to control economic growth, and thus inflation. When the economy is getting too strong, the government will attempt to "tighten" monetary policy by raising the Fed Funds rate, which is the interest they charge the banks for overnight loans. There is a lag of about six months before the effect works its way through the economy, so an action by the government usually indicates that they feel that inflation might be rising within the next six months to a year.
  • When the central bank hikes rates, a chain of events is unleashed whereby borrowing becomes more costly for banks who in turn raise their existing interest rates until ultimately it is more costly for consumers and businesses to borrow for consumption and investment. The end result is that the economy slows and inflationary pressures subside.
  • These changes are very important for businesses and consumers, because when the cost of borrowing increases, businesses invest less capital for growth, people spend less money on "big-ticket" items like cars and houses, and prices are kept in check. Thus, inflation is held back.
  • The Bank of Canada has traditionally followed the lead of the Federal Reserve. However the recent Fed hike was not followed by a Canadian rate hike because Canadian economic growth has not been as strong as it in the U.S.
  • The Bank of Canada has also raised rates in order to defend the currency. When the currency depreciates, foreign investors take a loss on Canadian bonds. Since the 80s, the large budget deficits forced the government to keep the currency strong to sell its bonds. This has had a deflationary effect on the Canadian economy and has kept the economy weak. Recently, The Bank of Canada has allowed the currency to fall because Canada is no longer a net new issuer of bonds since the budget deficit has been eliminated.

Economists and investors alike watch the leading economic indicators and statistics for signs of heated economic growth and potential inflation, rising industrial production and capacity utilization, dwindling inventories, high demand for commodities and industrial goods, and yes, even employment figures.

Traditionally, lower unemployment would signal a pickup in the economy and be followed by fears of wage inflation, which would trigger an interest rate hike. In recent years, especially in the U.S., this hasnít happened because of the way the labour market has changed in the new economy. Worker insecurity has become widespread since the massive layoffs at the beginning of the decade, and there has been a shift from high-paying career jobs into short-term, part-time or contract work, resulting in low unemployment without wage inflation.

For equity fund holders, the biggest danger about inflation comes from reduced corporate earnings. In particular, growth stocks- especially technology, Internet and biotech stocks- are valued based on the companyís future earnings, five years or more down the road. The specter for higher interest rates calls into question the ability of these growth companies to meet their revenue and earnings targets, resulting in a fall in their stock price. Higher rates also cause stock prices to fall because they reduce the present value of future earnings streams. The effect is most profound for growth stocks.

Interest-sensitive stocks also suffer a drop in price when rates rise. These stocks are traditionally banks, utilities and other dividend-producing instruments like income trusts and preferred shares. The interest-sensitive stocks all pay out a regular dividend. When rates rise the present discounted value of this earning stream falls so the value of the share is worth less. Hence, the stock price falls for interest sensitive stocks. This is the same reason bond prices fall when rates rise. The present value of the bondís coupons is worth less today when rates rise.

Therefore, investors can expect a drop in their portfolio value when interest rates rise and when inflation fears surface. Growth oriented funds, small cap funds, and dividend funds are the most affected. In the longer run, value-oriented funds and blue chip, large cap funds tend do better. Next time, weíll discuss how interest rates affect the other side of the investing universe Ė bonds and fixed income instruments.

Levi Folk and Richard Webb are editors of the Fund Counsel newsletter, a monthly publication for independent mutual fund investors. They can be reached on the Web at www.fundcounsel.com or by E-mail at editors@fundcounsel.com.

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