Why is the Bank of Canada Hiking Rates so Aggressively?
Rising rates are causing headaches for investors across the investment spectrum – however ETFs can be used to position into attractive areas.
Headlines are dominated by the aggressive hiking of rates from both the Federal Reserve in the U.S. and the Bank of Canada in Canada. Central banks have a mandate to maintain long-term inflation, and inflation expectations, at ~2%. Without price stability, the economy would not function efficiently and there would be an abundance of anxiety and uncertainty amongst the general population and investors alike.
In order to combat inflation, interest rates have been hiked very aggressively which has had a significant impact on investments across all asset classes. However, there are still a few pockets of investments that benefit from rising rates. Furthermore, Canadians can gain exposure to them through ETFs.
Insight on Bank of Canada’s Hiking Rates
The Bank of Canada has a mandate to:
- Preserve long and medium-term inflation expectations around 2%.
- Achieve maximum stable employment.
Currently, employment is essentially a non-issue given that unemployment has been bouncing along record lows amidst a nationwide labour shortage. However, inflation – and inflation expectations – are a different story.
The key word in the Bank of Canada’s mandate is inflation expectations. What matters more to individuals and investors is not the current inflation rate, but more so the expected inflation rate that they can expect in the future. Even though the latest CPI print was + 7.6% y/y – if there was an expectation that inflation would come back down to 2% quickly, there would be a lot less anxiety and fear amongst individuals and investors.
Inflation expectations anchor the decision-making that people make in their everyday lives. Unstable prices cause consumers and investors to have a volatile view of their spending/investing power. This makes it difficult to predictably save, borrow, or lend money. This causes a strain on the financial system and could lead to disastrous outcomes such as stagflation (rising inflation with little-to-no growth).
Therefore, to anchor consumer and investor expectations, the Bank of Canada must act in a way as to reduce inflation expectations, and their greatest tool in doing so is raising their policy rate.
Implications of Rising Rates
For investors, rising rates are a net negative since it makes the cost of borrowing much higher. This in effect makes the discount rate for all investments higher and investments less attractive relative to the risk-free government bond rate. The monetary tightening thus far in 2022 has already had a very pronounced effect on investments with stocks and bonds both performing poorly this year.
For stocks, raising rates make riskier investments less attractive since the risk-free rate is increasing. Also, rising rates will likely strain consumers and lead to less spending and lower earnings for many companies. Lastly, rising rates make debt obligations more expensive which impacts companies with greater leverage more severely.
For bonds, rising interest rates lead to a less attractive relative return to government bonds. In general, there is an inverse relationship between prevailing market rates and the prices of bonds.
ETFs to Consider in the Rising Rate Environment
While the picture that is being painted seems gloomy, there are some asset classes that offer greater investment potential in a rising-rate environment, although this is in no way guaranteed. This includes ETFs which give exposure to commodities and money market instruments.
CGL (iShares Gold Bullion ETF)
- AUM: $650M
- Expense Ratio: 0.55%
- YTD performance: -5.3%
CMR (iShares Premium Money Market ETF)
- AUM: $225M
- Expense Ratio: 0.28%
- YTD performance: +0.53%
Data for this article is as of August 30, 2022.
Please note this article is for information purposes only and does not constitute investment advice.
