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The Greenspan Effect
Why and how interest rates impact your investments

2001 is only a few days old and already one of my "predictions" has been proven wrong. Last week, I said that I do expect rates to fall this year but that it probably wouldn't happen until later in the year. Then US Federal Reserve Chairman Alan Greenspan goes and cuts the country's key interest rate by a half of a percentage point to 6 per cent. Most economists don't expect the Bank of Canada to follow Greenspan's lead this time, so I was half right. In any event, falling rates are still expected for North America and Europe throughout this year. Though we often see the impact on investments in the morning paper, this week we'll examine why and how interest rates impact investors.

Interest rates - a policy tool

Governments generally have two types of policies at their disposal in managing the economy - fiscal and monetary. Fiscal policies deal with government spending while monetary policies involve the money supply and interest rates. Interest rates are essentially the cost of acquiring or borrowing money. All of these policies are basically used by the government to attempt to keep the economy in a "Goldie Locks" range - not too hot and not too cold. If the economy is too sluggish, spending slows, job cuts accelerate, and the risk of recession sets in. An economy that is growing too rapidly is illustrated by consumer overconfidence, accelerated spending by consumers and businesses, excessive borrowing, which eventually results in high and rising inflation. Neither extreme makes for a healthy economy so keeping growth within a certain range is important.

Background

The Federal Funds Rate is the interest rate that the US government charges banks for short-term borrowing. The rate is changed by the Federal Reserve as a tool to influence the demand for money and, in turn, economic growth. Prior to this past week's rate drop, the Fed Funds Rate was 6.5 per cent, where it sat for several months after the rate hikes of 1999. The last time we had seen it that high was in early 1991, when the Federal Reserve began dropping rates to bring the economy out of a deep recession. This key interest rate was actually in the double digit range in 1989, before dropping below 7 per cent back then. Rates continued to fall steadily to below 3 per cent in 1993.

Impact on fixed income

Investors often forget the basic relationship between bond prices and interest rate changes. Wherever interest rates go, bond prices go in the opposite direction. Suppose you buy a five-year government of Canada bond for $1,000 that pays 6 per cent in annual interest. Exactly one year later, what do you think your bond is worth if the government of Canada is issuing four-year bonds for $1,000 that pay 7 per cent (or $70) annually? Answer: your bond would fall in price.

There is actually some logic to this. Recall that your original bond pays $60 per year in interest. One year after you bought it, your five-year bond is now a four-year bond. If the government is issuing four-year bonds that pay 7 per cent (or $70) annually, why would anybody still pay $1,000 for your original bond which pays 6 per cent (or $60) per year? In order for your bond's $60 annual interest payment to remain attractive to other investors, the price of the bond must fall.

Generally speaking, interest rate changes have this impact on all fixed income investments. However, with many such instruments (like preferred shares, convertible bonds, and callable bonds) there are other factors that affect their prices, so the impact of interest rate changes isn't as strong as with straight government bonds.

Impact on corporate profits

The impact of interest rate changes on corporate profits might be more logical to most. Companies typically carry some debt to finance expansion projects or for refinancing purposes. For those companies who have a fixed rate on their debt, interest rate changes don't mean a whole lot. However, companies with short-term debt and other debt with a floating interest rate will feel interest rate changes immediately. In such instances, a drop in rates reduces a company's cost of servicing existing debt and makes borrowing more money a little more attractive. If companies' interest costs fall (all else remaining equal) net profits rise. If a rate decline is expected to persist for some time, it could also have a positive impact on earnings projections. It also follows that a rosier earnings picture often translates into a rising stock price.

Taking that logic a bit further, some companies can be more sensitive to rate changes than others. Firms that carry no debt may not feel rate changes as much as those that are highly leveraged (i.e. carry lots of debt). Financial services companies like banks, insurers, and other lenders are often more sensitive to interest rates since their core business is so closely tied to interest rates. Utility companies are also considered "interest sensitive" sector.

While this is a rather simplistic look at the impact of interest rates, I hope it has broadened readers' understanding of the basic relationship between interest rates and their investments.

Next week: a deeper look into the relationship between interest rates and stock prices.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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