February 2015 Market Performance

All index returns are Total Return (includes reinvestment of dividends) and are in Canadian Dollars unless noted.

*Absolute change in yield, not the return from holding the security.

Market Update

Markets in February resumed their upward trend following a number of stumbles in January. Following the surprise moves by the central banks in Switzerland and Canada, currency and fixed income markets returned to more normal trading in February. The top performing equity indexes for the month were found in the US and EAFE markets, while Canada and Emerging Markets lagged. European equities have done quite well so far in 2015, with Germany leading the way up more than 12%. Given the positive performance in equities, unsurprisingly equity volatility both realized and implied, declined.

Bonds were mixed, with the major Canadian index, the FTSE TMX Universe down for the month, while lower grade US bond indexes were positive, outperforming investment grade bonds. The Canadian Dollar strengthened in February against both the US Dollar and Euro, but remains lower YTD against both. While most Canadians have been following the Canadian Dollar’s progress against the US Dollar with dismay lately, the Euro’s decline has matched pace with the Loonie’s decline.

Are Interest Rates Really Going to Go Up?

Every time I hear that interest rates are going to go up I let out a big sigh. My skepticism of rising rates started in the spring of 2009, just after it seemed that financial markets were turning the corner. At that time many market commentators began calling for interest rates as set by the major central banks such as the US Federal Reserve and Bank of Canada to begin rising again by the end of 2009. Those central banks and others around the world had rapidly cut their benchmark interest rates to help stave off a much worse financial situation following the failure of several US and global investment banks.

Most commentators seemingly ignored the massive amount of debt in the global financial system that was continuing to grow with each new bailout. It was clear to me and a minority of commentators that interest rates were not going to go up any time soon. As central banks continued to delay raising their benchmark interest rates well into 2011 and 2012 and the situation in Europe continued to erode, central banks instead began to introduce additional monetary easing policies in an attempt to force their respective economies into growing. This confirmed my view that interest rates were not going to rise by 2014 at the latest as many at the time were suggesting. Meanwhile, yields in the bond markets continued to decline and in some cases actually turned negative, providing further indication that interest rates were not going to rise any time soon. Today the yield on US government 10 year bonds is around 2% and the yield on the 30 year remains below 3%. Yields on German government debt (commonly referred to as Bunds) are even lower. Japanese debt yields even less and has done so for a long time. In fact Japanese interest rates have been under 2% since 1995.

source: tradingeconomics.com
In light of that graph, why couldn’t US, Canadian and European interest rates stay where they are for another decade or two?

Now that the U.S. Federal Reserve has ended its quantitative easing program, forecasts for higher interest rates are again coming to the fore. The Bank of Canada surprised many by cutting its benchmark rate in January by 0.25% (a Morgan Stanley report the week before the announcement said there was a 33% chance of a rate cut). A number of less influential central banks also cut their interest rates, providing further indication that outside of the U.S. all is not well.

There is a very real possibility that a return to a “normal” level of interest rates is not in the cards for many years; I wouldn’t count on 5-year GIC rates to return to 5% in the next 5 years. With inflation remaining very low, largely due to a sharp decline in energy costs, there is little need for interest rates to increase due to rising inflation (remember all those calls for runaway inflation in 2009 due to the U.S. Fed’s actions?). Until all of the economic excesses of the last 10-15 years run their course, there is little likelihood that inflation will become a problem.

If you have a well diversified portfolio then interest rates remaining low should be less of a concern to you. You may be tempted to adjust your chosen asset classes in the fixed income portion of your portfolio to compensate for lower returns on that part of your portfolio. Recall that many investors were burned in 2007 and 2008 when reaching for incremental yield in supposedly safe asset-backed commercial paper (ABCP). With interest rates so low, any small moves up could spell large losses for fixed income portfolios.  It may be wise reduce the duration (sensitivity to changes in interest rates) of your fixed income portfolio, thus decreasing your interest rate risk. A number of managers offer fixed income funds that actively hedge interest rate risk and there are ETFs that offer this as well. Another course of action that could be considered is reducing exposure to government bonds in favour of corporate and/or high yield bonds. But keep in mind that while these bonds are still subject to some interest rate risk, you are increasing your exposure to credit risk (the risk that the issuer will default). Another course of action to consider is increasing your exposure to equities by allowing your fixed income allocation to remain at the bottom of your rebalancing band rather than rebalancing to its target weight.