How will my clients’ investments be affected by falling rates?
Perhaps this is a question your clients have been asking now that the U.S. has implemented a 50-basis point rate cut, and Canada has been cutting rates too.
Let’s look at the two primary asset classes, fixed income or bonds and equities.
As rates go down, bond prices tend to go up. Why is this?
When interest rates fall, bond prices tend to increase, and vice versa. That’s because the government bond you bought with the 5% yield becomes more attractive when you can now only buy a government bond with a 4% yield.
Let’s break this down a little further. Let’s assume the 5% bond was purchased one year ago and today’s rate on a 4-year bond (maturing at the same time as the 5-year bond) is crediting 4%. Which bond would you rather own and have mature in four years? Obviously, the 5% bond. So, if the owner of the 5% bond decided to sell the bond in the open market today, people would pay a premium for it because of the higher yield. In other words, this bond is worth more that a current 4-year bond.
With respect to equities, it’s a bit more complicated as many factors affect a stocks price. If we were to eliminate all other factors contributing to a stock's price except interest rates (the cost of borrowing), lower interest rates would have a positive effect on stock prices. Why, because the cost of borrowing would be lower and save companies money, hence increasing their profits. But be very careful because we can’t just think equity markets will rise when interest rates are lowered as there are so many factors influencing stock prices.
Here's a great picture from the Visual Capitalist website.
As you can see, on average after rate cuts, the S&P 500 3-month average returns are -1.1%; after 6 months 4.4% and after 1 year, 4.9%.
Considering how lower rates will impact your clients’ portfolios is a good exercise to go through, and is it time to move GIAs and HISAs back into the markets? We’d be glad to help you with this analysis.
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