May 05, 2015

What Drives Interest Rates?

With interest rates at record low levels, investors ranging from long-term investment funds (Pension Plans & Endowments) to individuals planning for retirement are facing a number of unique challenges.  So what drives market interest rates?

In the short-term, market interest rates can be driven by a number of factors including economic data, central bank announcements, financial conditions (including stock and currency markets) and overall sentiment.  Following the surprise decision in January 2015 to cut the Overnight Lending Rate (i.e. the rate at which financial institutions borrow and lend funds between themselves) by 0.25%, interest rates in Canada have been highly sensitive to comments from the Bank of Canada.  For instance, the Overnight Lending Rate is currently 0.75%, while 2-year Canadian government bond yields are 0.59%.  This implies the market is expecting the Bank of Canada to cut rates for some period of time in the next 2 years, otherwise an investor would be better off lending shorter term and earning the higher rate.

Over the long-term, market interest rates are driven by economic growth, inflation expectations and other extraneous factors.  In Canada, inflation expectations are reasonably well anchored at the Bank of Canada’s inflation target of 2%.  So let’s consider real (i.e. inflation-adjusted) yield.  The Government of Canada 10-year bond yield is currently 1.4%, which offers a real yield of minus 0.6% (1.4% yield less 2% inflation) over 10 years.  This is particularly important because, in theory, real yields should somewhat track real economic growth expectations.  The question then becomes, does the market expect an extended period of negative real economic growth in Canada?  In a closed economy, perhaps this would be true.  However, in an integrated global economy, the difficult economic conditions in Europe (which was the impetus for their implementation of US-like Quantitative Easing) and lower energy prices, have exerted significant downward pressure on global inflation expectations, resulting in negative government bond yields in several European countries.  In turn, this affect has filtered through to other countries, including Canada.

In the end, market interest rates are driven by a number of factors but their relationship is not always consistent.  Currently, the Bank of Canada’s desire to stoke economic growth is the main reason for maintaining very low short-term interest rates.  This definitely affects long-term interest rates but is not the main contributor.  Long-term interest rates are currently low due to low global inflation expectations and moderate growth potential in Canada due to lower oil prices, a heavily indebted household sector and a weakened manufacturing base due to relatively high unit labour costs.  Even with a weaker currency and a partial reversal in recent oil price declines, these issues will moderate any increase in long-term interest rates in Canada.  However, as the global economic recovery continues, long-term interest rates in Canada and elsewhere will nonetheless start to slowly rise.

Forward looking statements are based on our assumptions, results could differ materially.

Jonathon Palfrey

Managing Principal, Portfolio Manager - Private Clients & Foundations