What do today's higher interest rates mean for investors?

As central banks take wait-and-see stance, portfolio manager sees ‘new dawn’ for bonds and potential opportunity for stocks

What do today's higher interest rates mean for investors?

With interest rates now hovering at elevated levels following the most recent decisions from the Bank of Canada and the Federal Reserve recent decisions, investors might want to consider increasing their allocations to bonds and stocks, according to one portfolio manager.

“Holding policy rates usually suggests that central banks believe current monetary policy is appropriate for the economic conditions. If they were to raise rates, it might indicate concerns about inflation, while lowering rates could signal worries about economic slowdown,” says Graham Priest, investment advisor and portfolio manager at BlueShore Financial. “At present, we have a hold, which likely means that they see things as relatively stable.”

Central banks holding higher for longer

While inflation is still above policymakers’ 2% target on both sides of the US-Canada border, headline CPI has been on an overall promising trend of decline. That gives both the BoC and the Fed some breathing room to pause, Priest says, as full effect of their aggressive hikes will likely take time to make its way through the system.

Looking at the markets, Priest sees signs pointing to rate decreases in the second half of 2024, though that remains to be seen. Any decision to lower rates won’t come soon, he says, as central banks won’t want to cut their policy rates only to quickly turn around and raise them again.

For its part, the BoC has warned businesses and households to plan for higher interest rates compared to the experience of recent years.

“It's not hard to see a world where interest rates are persistently higher than what people have grown used to," Senior Deputy Governor Carolyn Rogers reportedly told Advocis Vancouver last Thursday, stressing “the importance of adjusting proactively to a future where interest rates may be higher than they've been over the past 15 years.”

With at least 18 months typically needed for rate hikes to filter their way through the economy, Priest expects central banks to keep holding rather than imposing more hikes to push inflation down further.

“There are people who are going to be renewing mortgages in the next two years, that have yet to have their mortgage payments impacted by the increase in interest rates. … That's going to have a big impact on discretionary spending for those individuals,” he says. “If you look at mortgage applications in the United States, they’re at incredibly low levels, comparable to the beginning of COVID when everything shut down.”

A bullish moment for bonds and stocks?

Against this backdrop of elevated interest rates, Priest sees a new dawn for bonds. After an extended period of historically low interest rates, he says the extreme rate-hiking campaign by central banks has led to a three-year bear market for bonds. While some people are still scarred from that, Priest says an attractive risk-reward picture in fixed income today.

“If interest rates were to rise a little bit more from now, say another 1%, you might find bond prices would decrease vey little,” he says. “If rates were to remain unchanged or to fall, you’re at much better rates of return on bonds moving forward. So the environment we have for bonds right now is very attractive.”

Over the past year, investors have rushed into money-market and cash alternative products, which Priest says could be due to a preference for safety and liquidity amid market uncertainty, as well as higher interest rates on cash today than what investors have seen for some time.

But if history is any indication, Priest says that mad dash for cash could also give way to a strong period for equity markets. “There have been periods – like the dot-com bubble, the global financial crisis, and the early days of COVID – where we had cash holdings peak in relative terms compared to history. The equity markets do tend to perform well from that point onwards.”

If there is indeed a window of opportunity opening for stocks, it isn’t going to stay open forever. With interest rates more likely to go down than keep elevating, Priest says anyone looking to deploy their cash later on might not be able to find the same opportunities present today.

“Although those interest rates on cash are attractive do seem compelling, there are yields available right now on equities – like high-quality utility stocks – that might not be around this time next year,” he says. “It’s quite possible that some of these stocks that have been beaten up will gain in value. And thus, if somebody is buying them at this time next year they won’t receive the same dividend yield then, so now is a good opportunity for investors to be reassessing and rebalancing.”