Interest-rate hike: how should you position portfolios?

Company president assesses what is expected to be the first of many increases

Interest-rate hike: how should you position portfolios?

Brian D’Costa, President of Algonquin Capital, wasn’t surprised when the Bank of Canada announced that it was increasing its target for the overnight rate by 25 basis point to ½%, with the bank rate at ¾% and deposit rate at ½% yesterday. But, he has recommendations for fixed income portfolios.

D’Costa noted that the bank made it clear in January that inflation was running above the 1% to 3% rate band that it wanted. So, the bond market didn’t react yesterday because he said it was fully expecting, and had adjusted to, this rate hike plus more for the future.

“Nobody knows what the right level of interest rates for the Bank of Canada will be, but the bank is very certain that 25 basis points is not the right level,” D’Costa told Wealth Professional. “But, right now, the bond market is expecting the Bank of Canada to lift the overnight rate to somewhere around 1.5% over the next 12 months, so no one should get terribly fussed about this or that meeting.

“But, I would caution that I think there’s a non-trivial risk that inflation is more persistent than the central banks believe it is. The Bank of Canada cannot allow inflation to remain elevated for years. Otherwise it will become entrenched, and then we have a much more difficult problem to deal with.

“I think that there is a risk that central banks may push the rate higher than anyone imagines today with the idea that we would risk a shallow recession to make sure inflation doesn’t get entrenched and to avoid the need to have a deep recession to force rates to a point where we have a deep recession,” he added. “So, I think that people shouldn’t be complacent in thinking that rates can’t go too high, because they can, at least for short periods of time.”

The bank said consumer price index inflation (CPI) is currently 5.1%, and it planned to use its monetary policy tools to return inflation to the 2% target and keep inflation expectations “well-anchored”. But, it said the invasion of Ukraine was putting more upward pressure on prices for energy and food, so “inflation is increasing the risk that longer-run inflation expectations could drift upwards”.

What D’Costa was surprised about was the fact that the bank didn’t announce quantitative tightening, and “I think that is a nod to the uncertainty of the war. The comment was they will address this in future,” he said. “So, I found the commentary a little bit dovish, but they’ve made it clear they’re worried about inflation and it’s going to be elevated.”

D’Costa said it will be hard for bond yields to move lower, so people shouldn’t be surprised to see them drift higher in the next year. He said short-term investment should be centred in a short maturity type of bond products now, though there is currently big opportunity in credit, too.

“We are seeing a very large divergence in corporate bonds, and I’m talking investment grade bonds,” he said. “What we’re seeing is quarter corporate bonds are losing value this year, so credit spreads are widening.”

He noted that the markets are volatile daily now and the year-to-date is down 1%, but corporate credit spreads are 30-40%. So, he said, “credit is offering a great spot in fixed income right now because you’re going to get an enhanced yield, which will help protect you a little bit against further losses being created by increases in interest rates.”