• This week’s kickoff to the Federal Reserve rate cutting cycle officially marks the end of an era.
• While the Bank of Canada has been cutting rates for months, U.S. investors have been able to hide out in short-term Treasury bills and earn 5% returns until very recently.
• This normalized interest rate era has been a boon for savers who spent most of the last 15 years taking more risk than they were comfortable doing, just to outearn inflation.
• Portfolio stalwarts such as bonds and dividend paying stocks have historically done well once rate-cutting cycles commence, while stocks in general have also performed.
• While we do not think we will revisit zero interest rates anytime soon, new tactics will be required as we go back into a rate-cutting cycle.

2022 saw the beginning of a long-awaited normalization of interest rates. After spending most of the prior 14 years with interest rates closer to zero than 5 percent, long suffering savers greeted this news with glee. The transition wasn’t so easy on nearly every other type of investor, however. While we don’t want to reopen old wounds, recall that 2022 was one of the most challenging years for investors in some time as both bonds and stocks delivered negative returns, with “nowhere to hide” except cash and cash equivalents such as Treasury bills. This transition to higher yields gave investors the option to “T-Bill and chill”. In other words, take minimal risk in portfolios and earn a reasonable rate of return on short-term government guaranteed treasury bills, kick your feet up and relax.

Cash becomes less attractive as rates fall…

As the Bank of Canada and now the Federal Reserve engage in interest rate cuts, this strategy is on borrowed time. Indeed, T-bills represent the very definition of reinvestment risk. Every few months these instruments mature, and investors will be exposed to changes in short term interest rates, the trend of which for the foreseeable futures seems to be down. This is one of the reasons the yield curve has been “inverted”, with longer maturities yielding less than shorter ones. Investors were willing to take a lower rate of return in order to lock that return in for a longer period of time, taking a short term hit to returns in exchange for longer-run certainty.

… so what should we do?

The next logical question is what should we do when interest rates start to fall. The simple answer is to just get invested, be it in bonds or stocks. As seen below, both stocks and bonds have historically fared well in the 12 months following the first Federal Reserve interest rate cut. Bonds have seen a higher batting average as lower rates directly translate into higher bond prices while the return on stocks has been more dependent on what happens to the economy but in general the trajectory has been up.

Bonds are a good place to start…

Shifting gears to Canada, we can see below that the Canadian bond market has handily outperformed a 1-year GIC in the first year after the Bank of Canada starts to cut interest rates. We would note that the hurdle rate will be a bit higher this time around as 1-year GICs were in the 5% range when the Bank first started to cut interest rates, but of course bond yields were also higher than they have been during the commencement of the past few rate cutting cycles.

 

… as are dividend paying stocks

We shared a chart in our August 6 note that showed the rebound in dividend paying stocks as bond yields started to fall in advance of interest rate cuts. This was after a period of meaningful underperformance for these sectors, and sentiment hitting a deep low point. If we look at rate cutting cycles as a whole, this trend seems to continue. As seen below, U.S. dividend payers have tended to outperform the S&P 500 right through the rate cutting cycle. While high dividend yields don’t tend to attract investors when safer bonds offer similar cashflow, they do recognize the opportunity pretty quickly once bond yields start to fall.

Action trumps inaction when rates are falling

Warren Buffet has famously described one key facet to his process as follows: "Lethargy bordering on sloth remains the cornerstone of our investment style”. This was from Berkshire Hathaway’s 1990 shareholder letter following a year in which the company neither bought or sold a share in five of its six major holdings. An ultra-low turnover strategy can provide superior returns when one is invested in a collection of strong businesses that compound cashflows over time. The same, however, cannot be said for maximizing returns on cash when interest rates are falling. The era of “T-Bill and chill” is over, and in order to preserve today’s high yields, investors need to take action by terming out their maturities or alternatively, consider an asset allocation shift into dividend paying stocks in search of better total returns.

The Harbour Group

416-842-2300

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