The first rate cut since 2020 made by the Bank of Canada this month has renewed hope that inflation is closer to getting under control and that improved economic conditions will emerge over the longer term.
However, the impact of the quarter point reduction to 4.75 per cent on ultra-high-net-worth and other investors will not be determined for some time.
Brian Madden, chief investment officer with First Avenue Investment Counsel Inc. investment management firm and family office in Toronto, says the Bank of Canada “really needs to thread the needle” in terms of the decisions it makes involving rate cuts.
“They have to calibrate both the magnitude and the pace of rate cuts so as to engineer a soft landing for the economy, but without restoking inflation, which is right now on a favourable glide path down towards the 2-per-cent target, but just hasn’t quite yet reached that level,” he says.
James Thorne, chief market strategist with Wellington-Altus Private Wealth (Wellington-Altus Financial Inc.) in Toronto, says he expects the recent 25-basis-point rate cut by Canada’s Central Bank has started the process of rates trending downward.
The yield curve inversion problem
“But it is inconsequential, insofar as what really matters is the interest rate structure. The relationship between short-term money and long-term money has to get back to normal,” he adds, noting that there is a currently a long-standing yield curve inversion with interest rates higher for short-term money than for long-term money.
When interest rates are higher for short-term money than long-term money, credit creation in the private sector stops, and that it what has happened in Canada, says Thorne. And so the key question is when a normalized weight structure will emerge whereby short-term rates are lower than long-term rates, he elaborates.
Madden says Canadian investors could, in general, be advantaged by the rate cuts in Canada to the extent there will likely be some selling pressure on the Canadian dollar and corresponding strength in the U.S. dollar, adding additional currency thrust to an already strong U.S. stock market, which most investors have meaningful exposure to.
The effect on high-net-worth portfolios
But high-net-worth individuals have large portfolios, which in most instances are going to include some allocation to fixed income and bonds.
The impact on that part of their portfolio is “marginally negative, given the rate cut, because the re-investment yield on maturing bonds could prospectively be lower if Bank of Canada rate cuts shift the entire yield curve downwards,” says Madden.
“There is some evidence of that happening,” he adds, noting that bond yields were marginally lower in the immediate aftermath of the first announced rate cut, and that those yields dropped more for short-dated bonds.
“And so investors want to be thinking out over the horizon to determine if there are going to be more rate cuts. Because if this first 25-basis-point rate cut is just the first shot across the bow in a more aggressive easing campaign, then high-net-worth and ultra-high-net-worth investors may need to rethink their existing allocation to bonds in light of lower yields and prospective returns,” he elaborates.
Furthermore, he notes, most high-net-worth and ultra-high-net-worth investors, including family office clients, have allocations to long duration real assets, such as private equity and real estate.
“Those two asset classes, other things being equal, do tend to appreciate in periods of falling interest rates,” says Madden.
The effect on owners selling businesses
To the extent those individuals are thinking about monetizing or selling their operating businesses, the exit scenarios available to them are likely to become more plentiful as capital becomes less costly and more available if there is a meaningful cycle of interest rate cuts, says Madden.
Therefore, the rate cuts should, on a net basis, “prove advantageous for savvy high-net-worth and ultra-high-net-worth investors,” he elaborates.
Thorne says that a 25-basis-point drop in rates, while nice to see, is not nearly enough. Rates need to go substantially lower, he says, adding that monetary policy works with long lags, as has been acknowledged by Bank of Canada Governor Tiff Macklem.
The full effect of just that first rate cut will not be felt for about 18 months, and so the economy will continue to experience tough times well into the near future, he predicts.
‘Rate cuts always take longer than you think’
“[But] even if they cut aggressively now, which they aren’t, it would take 18 months for that effect to get into the economy.”
Analysts also took note of the fact that the Bank of Canada’s rate cut preceded any similar move by the United States Federal Reserve.
Madden believes the Bank of Canada is doing the right thing by cutting rates in advance of the Federal Reserve. He notes the Canadian economy is structurally less dynamic than that of the U.S. and accordingly has a lower potential growth rate.
There are also productivity woes and disincentives to invest here in comparison to the U.S.
The Canadian economy is also under more cyclical pressure than that of the U.S. and, as a result, a restrictive monetary policy is felt more acutely in this country, he adds.
He notes that higher rates create more financial strain in Canada than in the U.S., given elevated household debt levels and a mortgage market that is more sensitive to changing interest rates.
“In the U.S., homeowners can, and frequently do, lock in rates for 30 years, whereas in Canada the five-year fixed-rate mortgage is prevalent, exposing homeowners to potential ‘rate shocks’ on renewals.
Moreover, an increasing number of homeowners took advantage of what proved to be very tempting but ultimately rather fleeting low variable rate mortgages during the 2019-22 time frame, only to later feel the sting as rates rose sharply in 2022-23,” he elaborates.
On the consumer side, Canada also has higher levels of aggregate household debt, much of that related to mortgages.
However, “none of this really plays out impactfully in ultra-high-net-worth, or even the high-net-worth household space, because by, and large, these folks tend to be mortgage-free,” says Madden.
The effect on the loonie
“So I would suggest that the Canadian dollar is trading at a discount to the U.S. dollar because of the economic fundamentals of this country, not because of the interest rate differentials,” he stresses.
There is a well-known home bias whereby the average Canadian investor invests about 53 per cent of their portfolio in Canada, says Thorne. He notes that somebody running a global macro fund out of New York or London and looking objectively at exposure to Canada would allocate only perhaps 2 per cent to this country, given its relative economic impact.
“I think Canadians have an overexposure to Canada,” he stresses. “People are going to eventually understand that having 53 per cent of their portfolios in Canada is too much, and maybe it should be a lot less.”
Bottom line, the most recent 25-basis-point rate cut doesn’t change the bigger picture for Canadian investors, including wealthy ones, Thorne says.
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