The Bank of Canada’s interest rate cut in June was slight, yet significant. It was the first rate reduction in more than four years and a signal of cuts to follow, which we are already seeing.
One of the first things that interest rate cuts bring to mind is lowering the cost of borrowing, but they can also affect investment performance.
Changes to fixed income
When rates were higher, some investors chose guaranteed investment certificates (GICs) and money market funds with dollars they normally allot to bond investments. Lower rates make GIC and money market returns less enticing to meet long-term goals.
Interest rate cuts are generally good news for current bond investors. New bonds pay lower rates, which makes older, existing bonds with higher yields more valuable in the bond market.
Equity investment considerations
Interest rate cuts potentially support the stock market, as they reduce the cost of corporate borrowing and encourage customer spending. Historically, certain sectors (for example, real estate, utilities, consumer discretionary and information technology) benefit more than others. However, several factors affect stock market performance, so rate cuts alone cannot guarantee market success.
It’s debatable whether it’s desirable to buy specific equity investments in an effort to benefit from decreasing rates. Some money managers take an active approach, favouring companies in sectors they believe will outperform in a lower interest rate environment. Others believe in maintaining well-diversified portfolios that are designed to perform well in the long term, without basing investment choices on anticipated market changes. Each approach has its followers; it’s really a matter of which suits an investor’s risk tolerance and personal preferences.
Note that this time around, any effects that interest rate decreases have on investments may be gradual. Incremental cuts starting at 0.25% take time to work their way through the economy.