Interest rates, central banks and asset bubbles

Financial weekly update - July 7, 2017

July 7, 2017

What a difference a year makes. It seems only yesterday we were talking negative interest rates in Europe (which still exist to some degree) coming to North America. There were whispers that the US would move to negative if needed to support the markets and Canada spoke of lowering rates from 0.50% to 0.25%. Europe seemed to be saying every other day, that they would do whatever was necessary to protect the markets, even if it meant going further negative with rates. Japan went negative and remains there.

As you probably know by now, negative interest rates are when governments pay people and corporations to borrow money with the idea that more money will flow into the economy spurring economic growth.
Lately, the tone has changed and it has changed globally. The new mantra is normalizing interest rate which is “banker language” for raising rates. The US has raised rates three times since December 2015 and are signaling three or four more hikes in the next six to eight months. We shall see.

Then in a surprise move, the Bank of Canada started talking about raising rates as well, even though inflation is well below their own self-imposed target of 2%, the price of crude oil is very low and with an uncertain US-Canada trade situation. It was a curious statement that caught the market off guard. Our loonie has since soared as the bet is heavily skewed to a 0.25% raise on July 12th. The loonie appears to have overshot the runway so a correction is quite possible after the announcement.

Why the sudden reversal?

A few factors are obvious, the least of which is an improving global economy. It isn’t a Thoroughbred market by any means, more like a Clydesdale plowing through the muck, but plowing forward nonetheless. Another factor that likely entered into it is a fear of asset bubbles. I am referring to bubbles in real estate and stock prices getting too rich and rate hikes are a mechanism that can be used to slow this bubble down before it pops and crashes.

It is worthy to note that since the 2008 financial crisis otherwise known as the Great Recession, central banks worldwide have been working in concert to work what we call financial engineering. The latest statements of normalizing rates come shortly after a meeting last week in Portugal with the Bank of Canada, the US Federal Reserve, the European Central Bank and the Bank of England all present.
If the policy change is a concerted effort and the fear isn’t inflation but rather asset bubbles then rates will rise and then all will watch and see what the market reaction is. To date, most believe that rate hikes are written into the market and what the market really waits for is the comments afterward.

There are risks to the markets, there always is.

Right now Canada faces risks in high real estate values in Vancouver and Toronto and low crude.
The US indexes are richly valued. Europe, while calm as of late, always has the overhang of dissent.
Emerging markets need strong domestic markets in developed countries to buy their goods. Yes, there is always something to worry about but for now, the signals are favouring equities over bonds. The wildcard to derail the markets is always unknown but using a Rules Based system we mitigate the damage. We don’t try and predict but if history is a guide, the January 2016 crash was caused by $26 oil. If we see a sharp drop in crude prices we may see a contagion with other asset classes. But then again, that is only conjecture but if it does occur it we might see another huddle by the Central Bankers.

Daryl Cooper
Portfolio Manager
Director, Wealth Management