A new direction for the Fed
After many years of 0% rates and aggressive stimulus, we expect the Fed to hike rates multiple times in 2017, something it hasn’t done since 2006. In the rate-tightening cycles in the past 30 years, the Fed Funds rate was at an average of 7.8% when a U.S. recession emerged. Rate hikes aren't a disaster for stocks or bonds. Since 1986, in the three years following an initial Fed rate hike, U.S. stocks returned an annual average of 9.2% and Canadian stocks returned 11.7%.1 Importantly however, the average volatility for bonds was notably lower than that of stocks, meaning that even when the Fed is hiking rates, bonds still provide portfolio protection against market volatility.
Low inflation keeps the Bank of Canada on hold
The overnight interest rates set by the Bank of Canada (BoC) and the U.S. Fed are close to each other, but the path ahead for central bank policies will remain different this year. We think prevailing low inflation pressures and more modest economic growth in Canada will keep the BoC on the sidelines for a while. Core inflation has been below 2% for five consecutive years, providing the flexibility to hold rates low for a while longer in an effort to support the economy. We think longer term rates will remain fairly low this year (10-year rates have risen from their lows of last fall but have remained below 2% since 2014), with an acceleration in GDP growth and/or a jump in inflation expectations needed for rates to move substantially higher in the near term.
Keeping a lid on the loonie
Interest rate differentials (along with oil prices) are the primary influence on the direction of the Canadian dollar. The downside gap between 10-year yields in Canada and the U.S. is the largest it's been in more than 30 years and we anticipate this gap to persist for some time this year given our expectations for growth, inflation and central bank policy. The lower loonie does offer help to export activity, though the effects have been modest to this point.
Action for Investors
Rebalance to a neutral fixed income weighting in your portfolio. Over time we still think equity returns appear more attractive than fixed income, however bonds can offer the value of portfolio stability in a more volatile market environment. We recommend adding to investment-grade bonds and reducing duration (maturities) to reduce interest rate risk. We suggest reducing high-yield bond exposure as yields are not compensating for the additional risk.
1. Canadian Stocks: S&P/TSX Composite Index, U.S. Stocks: S&P 500 Index
This information is for educational and illustrative purposes only and should not be interpreted as specific investment advice. Investors should make investment decisions based on their unique investment objectives and financial situation. Before investing in bonds, you should understand the risks involved, including credit risk and market risk. Bond investments are also subject to interest rate risk such that when interest rates rise, the prices of bonds can decrease, and the investor can lose principal value if the investment is sold prior to maturity. Past performance does not guarantee future results. Indexes are unmanaged and are not available for direct investment.