Here’s why most people don’t bet on horse races: Because sometimes the favourite steed might have strong odds but still loses.
Back in 2015, most experts—including here at Ratehub.ca—argued that the rates of return attached to GICs should rise in the coming months. That was because central banks in the United States and Canada were expected to boost interest rates during that period to coincide with growing concerns about pent-up inflationary pressures in both countries.
A funny thing happened however; while the U.S. Federal Reserve acted somewhat according to script and eventually raised its benchmark rate, the Bank of Canada cut the bank rate—twice—in an effort to boost Canada’s stagnating economic growth.
As a result, GIC rates dropped rather than rose in the ensuing 24 months.
Look back at May 2015.
Back then, the average interest rate on a one-year GIC stood at 0.88%, according to the Bank of Canada. Two years later, in April 2017, the average rate was a microscopic 0.73%, a 17-percentage point decrease.
It was the same story with the five-year GIC—1.5% in May 2015 compared to 1.13% two years later.
So, gazing into the investment crystal ball for the next 12 months or so, you would think experts might be more reticent to predict higher GIC rates. Well, you would be wrong; the drumbeat is again building for higher interest rates. That said, how these investment gurus arrived at that conclusion is still pretty sound.
GICs are an ultra-conservative type of investment whereby, say, you buy one that matures in three years. Then, in 2020, you get your principal amount back plus some interest. You don’t get a big payday when you cash in the GIC. But you also don’t face any risk of losing money either.
If interest rates fall within that 36-month period, you win because a corresponding investment with a similar risk profile would return less than the GIC. But, if rates rise, you lose because other investments now are worth more.
That’s why getting the direction of rates correct is important.
Right now, the target level for the Bank of Canada’s overnight interest rate is 0.5%, a historically low level. Experts figure, although the central bank cut that rate twice in 2015, Canada’s monetary authority is looking to hike rates.
They argue the policy agenda of U.S. President Donald Trump, less regulation and lower taxes, is designed to boost American gross domestic product (GDP) growth. If successful, however, higher economic growth would place pressure on the U.S. Fed to raise interest rates to deal with possible price hikes.
The American central bank already boosted its main domestic interest rate once in 2016 and could hit the ‘up’ button twice more in 2017, experts say.
Higher U.S. interest rates, however, could squeeze the Canadian dollar and force the Bank of Canada to boost our rates in order to protect the loonie’s value.
Thus, the reasoning for a Canadian interest rate increase is two-fold:
- 1. To keep our GICs competitive with other investment vehicles; and
- 2. To ensure that the Canadian dollar maintains its value compared to the U.S. dollar.
You can already see the upward trajectory of interest rates in various forecasts. According to the CIBC, a two-year bond had a yield of 0.75% in January, which the bank expects to rise to 1% by December and 1.25% by September 2018.
And those higher bond rates generally get reflected in rising GIC rates. RBC, for example, predicts that the rate for a three-month GIC will stand at 0.55% by the end of the third quarter of 2017. By the fourth quarter of 2018, a 90-day GIC will be returning 1.4%, a jump of more than 150% in 15 months.
So, once again, Canadian banks are forecasting higher GIC rates in the coming months—the prediction the same people made two years ago. And they were wrong.
The question this time around: Is the prediction of higher interest rates a risky bet or a sure thing?
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Flickr: Josh McGinn