Volatility has resurfaced over the past month. It has been most evident in the bond market, with yields having moved meaningfully higher (and prices lower), reaching levels seen in November of last year. The move in equities has been less pronounced, but the weakness is still noticeable. The culprit? Renewed uncertainty and debate over interest rates. We discuss this and more below.

 

Global economic data through the first few months of the year have been reasonably strong, defying many expectations for a softening in activity. In normal times, this kind of a backdrop would be cheered by most investors. Recent developments have fueled concern that inflation, while trending lower, may remain elevated and force central banks to raise rates further in order to cool demand.

 

Policy makers have started to offer conflicting signals. The Bank of Canada indicated that it will pause with its rate tightening and wait to assess how the economy is faring. More recently, the U.S. Federal Reserve suggested that it will need to raise interest rates further to get inflation under control. The bottom-line: investors are reassessing rate expectations, which has fueled the recent bout of higher volatility.

 

We do not yet have a high level of conviction on precisely where interest rates will land when the hikes end. Nor do we think that it matters as much as some pundits would suggest. In our view, what is more important is to prepare portfolios for the potential scenario in which interest rates stay high for a long enough period of time. Through history, most periods of rate tightening have ultimately resulted in slower growth, or outright recessions. We do not expect this cycle to be any different.

 

We do believe that investors need to be patient. Consumers still have the wherewithal to spend. Cash balances remain elevated, although they are on a downward trajectory. Consumers remain very willing to spend and experience the kind of activities – trips, outings, shows, eating at restaurants, etc. – that they missed during the pandemic period, regardless of cost.

 

It takes time for the full impact higher interest rates to work through the economy. The Canadian housing market is a good example. Canadians with mortgages make up about 35% of the country’s households (another 37% are renters and 28% do not have mortgages). Only a fraction of households (2%) have variable rate/variable pay mortgages with payments that fluctuate with changes in interest rates. A larger share of households either have variable rate/fixed pay mortgages (10%) or fixed rate mortgages (23%), and neither of these see any change to payments over the term of the mortgage. The bigger challenge will unfold over the next few years as mortgages mature and refinancing occurs at much higher rates. The refinancing households will then be required to reassess and reprioritize their spending and saving.

 

The trajectories of inflation and interest rates remain very important components of the economic and investment outlook. We will continue to observe economic data and recalibrate our expectations as matters evolve.

 

If you have any questions, please do not hesitate to contact us.

 

Drew M. Pallett LL.B. CFP

Senior Portfolio Manager and Investment Advisor 

RBC Dominion Securities         

Email: drew.pallett@rbc.com

Website: www.pallett.ca