Bank of Canada’s big gamble on raising interest rates

The central bank raised interest rates to 0.75 percent from 0.50 percent on Wednesday, its first hike in seven years. I am still scratching my head trying to figure out why?

Inflation figures have eased over recent months, the price of oil hasn’t recovered to the $60 level. Therefore, oil prices will keep headline inflation low. Foreign capital is still leaving the Alberta oil sands seeking cheaper oil production fields in the United States. Alberta’s unemployment rate is falling but it is still over 7 percent, not exactly booming.

The housing sector is responsible for 25% of Canada’s GDP growth. The housing bubble is already showing signs of bursting and household debt is at extremely high levels. Higher borrowing costs will dampen economic growth pushing core inflation further below target. Higher interest rates make mortgages more expensive and Canadians will have less money to spend.

Hedge funds have been shorting the Canadian dollar and our Canadian banks expecting a meltdown in housing. Add low oil prices to the mix and fund managers were betting on a big drop in value of our dollar. Surprise, the Canadian dollar has jump 5% in value against the U.S. dollar. When you add the fact that the United States receives 75 percent of our exports, the increased value of our dollar is going to make our exports more expensive which could further reduce economic growth.

The Bank of Canada’s own projections for economic growth don’t seem to justify increasing interest rates at this point.

“The Bank of Canada now expects the economy to grow 2.8 per cent this year, or faster than the 2.6-per-cent pace it predicted in its April forecast. GDP growth will slow to 2 per cent in 2018 and 1.6 per cent in 2019, the bank said.”

Is the Bank of Canada trying to shock Canadians to curb their appetite for debt financing? Will increasing the value of the Canadian dollar stop foreigners from buying Canadian real estate?

Many economist have made the argument that the two original rate cuts in 2015 were made as insurance to avoid a recession in Canada due to the falling price of oil.  That threat has been avoided and therefore the Bank of Canada is justified in taking back those two cuts.

My theory is the Bank of Canada is gambling with a temporary slowdown in economic growth in order to help our government renegotiate NAFTA. Talks will be starting soon with the United States. Keeping our interest rates close to the U.S. rates and a stronger looking Canadian dollar would certainly show good faith during the negotiations.

Where does it go from here?

Despite the housing market, some analysts believe the BOC will announce further rate hikes. Citi analysts predict two rate hikes this year (including Wednesday’s hike) but no more until the second half of next year. BoAML expects another rate hike in January of next year but says such decisions will be “data dependent”.

 

 

 

 

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Can the Yield Curve Predict the Future?

The U.S. Treasury “yield curve” compares the yields of short-term Treasury bills with long-term Treasury notes and bonds. The U.S. Treasury Department issues Treasury bills for terms less than a year. It issues notes for terms of two, three, five, and ten years. It issues bonds in terms of 20 and 30 years. All Treasury securities are often called “notes” or “Treasury’s” for short.

There are three types of yield curves. They tell you how investors feel about the economy. For that reason, they are a useful indicator of economic growth.

A normal yield curve is when investors are confident, and shy away from long-term notes, causing those yields to rise steeply. That means they expect the economy will grow quickly. What does this mean to you? Mortgage interest rates and other loans follow the yield curve. When there’s a normal yield curve, a 30-year fixed mortgage will require you to pay much higher interest rates than a 15-year mortgage. If you can swing the payments, you’d be much better off, in the long run, trying to qualify for the 15-year mortgage.

A flat yield curve is when the yields are low across the board. It shows that investors expect slow growth. It could also mean that economic indicators are sending mixed messages, and some investors expect growth while others aren’t as sure. When the yield curve is flat, you aren’t going to save as much with a 15-year mortgage. You might as well take the 30-year loan, and invest the savings for your retirement. Better yet, apply the savings against the principle and look toward the day you can own your home free and clear.

A flat yield curve means that banks probably aren’t lending as much as they should. Why? They don’t receive a lot more return for the risks of lending out money for five, ten or fifteen years. As a result, they only lend to low-risk customers. They are more likely to save their excess funds in low-risk money market instruments and Treasury notes.

An inverted yield curve is when short-term yields are higher than long-term yields. It’s an unusual situation where investors demand more yield for the short-term bills than they do for the longer-term notes and bonds. Why would this happen? They expect the economy to do worse in the next year or so and then straighten out in the long run. That’s why an inverted yield curve usually forecasts a recession. In fact, the yield curve inverted before both the 2000 and the 2008 recession.

Many market participants have pointed out that the bond market does not appear to share the equity market’s enthusiasm. As the S&P 500 rises to record highs, the 10-year Treasury yield has remained at rather low levels and is actually significantly lower on the year. This is all the more surprising given that short-term yields have risen as a result of the Fed’s rate hikes, so that the “yield curve” has flattened meaningfully.

The bond market appears to be saying that economic growth will not be particularly strong, particularly in the medium term an apparent rejection of the optimism that is being baked into stock prices.
It’s certainly common to hear it remarked that the bond market is “smarter” than the stock market, which is one of the reasons macro investors often look to the signals that the fixed income world is throwing off.

Should you be worried?

My daughter’s reply: What money lessons did you learn from your father?

“Enjoyed the article, thought I would write one of my own.” 

What money lessons did you learn from your father?

By Deanna Di Lello

 

When I was seven or eight years old my father took me to the bank to open my first savings account. I had been given ten dollars as a birthday present and it was going in the bank to earn interest!

When the account was set up I was handed my very first bank book. Whenever I had Christmas or Birthday money – in the bank it went and I watched the number in my book go up and up. My father taught me to save, but that’s not all he taught me.

The value of money

I earned an allowance as a kid and when I was old enough I got a paper route. Buying a toy with the money I had earned was much more satisfying than having it bought for me. Plus, I learned how much things cost compared to what I had earned. (I think I asked for my allowance to be raised on more than one occasion…)

Things really were better “back in his day”

When my brother and I were in high school we were told that when my dad was in university the money he earned from his summer job paid for his tuition. Those days were long gone. He asked us to work part time during the year and during the summer to earn money for school. He would cover the rest of our tuitions so we didn’t end up with student debt. We were extremely fortunate in this case as many of our peers did not have that luxury.

Pay the full amount on your credit card, not just the minimum

When I was nineteen and about to enter university I received my first credit card. I was told to use it to build up a good credit rating… but not to use it too much and to definitely pay off the full balance. I know many people drowning in credit card debit because they did not follow this advance.

Choose a partner who is good with money

The number one argument couples have is about money. My parents bicker sometimes, but not about how they spend. My mother’s values are in line with my father’s.

My husband had student debit from both his undergrad and post graduate degrees. As he changed jobs and earned more money, he would increase his payments. It was always a priority for him and as a result of his dedication, it has now been paid off.

It is better to give than to receive

For my parents’ twenty-fifth wedding anniversary, my father contacted my mother’s favourite charity and organized an award in her honour. This prize is awarded annually to a lucky recipient and my parents often attend the ceremony. It wasn’t the cash prize that moved my mother, brother and I to tears. It was the thoughtfulness of the gift. It was the knowledge that someone else’s life would be made just a little bit better thanks to his love.

Money doesn’t buy happiness… but neither does poverty

My father didn’t say this, but it’s true. His financial success was never motivated by the lure of bigger houses and more expensive cars. He only wanted to make sure that his wife and children were provided for.  That if there was ever an emergency that required a last minute financial expense, he could cover it.

 

My father taught me this and so much more.

 

“Thanks, Dad.”

 

What money lessons did you learn from your father?

To say that my relationship with my father was complex would be an understatement. I can’t imagine leaving Canada, going to a foreign country with no marketable skills, not being able to read, write or speak the language. That is exactly what my father did when he left war torn Italy back in 1952. A whole new meaning to “desperate times calls for desperate measures.”

Lesson one: Higher education can lead to better paying jobs

My father had very little formal education and at the age of 12, he left school to work the family farm. It is no wonder that I received many lectures on the value of a good education. It didn’t matter that I used to argue that some university courses didn’t really prepare young people for the working world. His reply was always the same. “You need that piece of paper” (a university degree)

We were both right, the university degree did help me to get my first job but I still had to go through a rigorous company training program. The university courses that I took had very little to do with my career.

Lesson two: The difference between needs and wants

There is no doubt that growing up in a low income environment taught me the difference between what I needed and what I wanted. Watching my dad stretch his paycheck to provide the bare necessaries in life was a real eye opener. It has stuck with me ever since and I still avoid spending money for luxury items.

Lesson three: Own the roof over your head

I am amazed that within six years my parents who were illiterate, with no education, manage to save enough money to buy a house. They earned extra income by renting a portion of our house for over ten years to assist with the mortgage payments. My mother still lives in that house and because it is located in Toronto, it could be worth close to one million dollars today.

Lesson four: Never spent money that you don’t have

My dad never owned a credit card. He paid for everything with cash or check.  A few times he did borrow some money from relatives to buy a new car or for medical bills before there was government paid health care. I know that my broken leg put some extra strain on the family’s finances when I was very young.

What my dad couldn’t teach me

Saving for retirement and how to invest your money

Being uneducated, he didn’t know that income from government pension plans would only cover a small portion of his living expenses in retirement. Despite his frugal life style, he would have had to sell the house at much lower prices than today. His untimely death and an inheritance from my mother’s parents has delayed the selling of the house for the past 25 years.

Happy Father’s Day!

Pass on what you know to your children!

 

 

 

What advice would you give for inheritance money?

 

Having been raised by two hard working immigrate parents, I was expected to help out with the household chores. Like most rebellious teenagers, I would have preferred going out with my friends. My complaints were answered with “someday this house will be yours.” I responded that I will be retired by then and won’t even need the money from your house. Funny thing is that I was right. Counting on an inheritance to fund your retirement can be very disastrous. (BTW, my mother still lives in the same house)

Thanks to bidding wars for real estate in Toronto and Vancouver, there are a fortunate few who will receive a sizable inheritance. Case in point, I recently got a call from a family friend of my wife’s whose deceased parents’ home sold for 50% over asking. Turns out that her inheritance was going to be much bigger than expect and she was hoping for some financial advice.

Her first question was “do I have to pay any tax on the inheritance”?  In Canada, the short answer is “no”, the estate of the deceased will pay all applicable taxes and what is left over is dispersed among the heirs.

My first question to her was rather delicate.  “How stable is your marriage”? A sizable inheritance, if not kept separate from family financial assets, could be included in a divorce settlement. (Using the inheritance to pay off the mortgage is a prime example)

What advice would you give to this couple in their mid-fifties who will be getting a windfall of $300,000?

Some personal information:

• Empty nesters, very stable marriage
• Own their own home, mortgage free, no other debts
• Husband works part-time, can’t find work in his field
• She has been working contract to contract for many years
• No company pensions
• Total savings of $55,000 in self-directed retirement accounts, combined unused contribution room of $80,000
• Zero dollars in tax free savings account, unused contribution room of $52,000 each

Additional information

1. Contributions to their retirement accounts will only generate a tax refund of 20%, tax free compounding but withdrawals are 100% taxable, required to start taking money out at age 72
2. Maximum contribution to TFSA is $5,500 each per year going forward. No time restrictions on withdrawals or amounts
3. The Canadian dividend tax credit has an extra 1.25% yield over interest income. (4% dividend equal to 5% of interest income)
4. Foreign dividends are 100% taxable plus have an extra 15% foreign tax

Their goal is to retire in 8 to 10 years.

Recommendations assuming the couple are willing to open different investment accounts.

How much money would you allocate to each account. (for example)

(a) $80,000 in tax differed retirement account, $104,000 in tax free accounts, $112,000 in trading account

(b) $104,000 in tax free account, 196,000 in trading account

(c) $300,000 in trading account

(d) put in an alternative mix

What asset allocation percentage would you recommend (equities / fix income, or gold…)?

What diversification mix would you suggest, short or long term bonds, index funds, ETFs, dividend stocks, growth stocks….

Would you be willing to pay 1% fee to an adviser for a selection of index funds and ETFs or an additional 1.5% to buy mutual funds? (Total yearly cost of $4,500 to $9,000)

Please email me your suggestions to ricodilello@rogers.com and I will comply all the recommendations in a follow up post.

 

 

Two questions from a blogger regarding mandatory retirement withdrawals by boomers

It has been awhile since I receive any questions from fellow bloggers that could be answered in a post. I thought that since I am a baby boomer, these questions might make an interesting post. This is what he wrote:

“I’ve seen more than one article regarding baby boomers starting to take mandatory retirement withdraws this year. This is the start of some significant money leaving tax deferred accounts for many years.”

1. Do you see this significantly affecting asset management companies?
2. Do you see this money going back into investments or going into daily living expenses and recreational “retirement” stuff?

 

Background and Research

Having worked as a financial advisor, the majority of my clients had little interest in saving for retirement. It was at the bottom of their priority list. It comes to no surprise that nearly half of U.S. families have no retirement account savings at all.

A 2015 Government Accountability Office study found that show that 29% of Americans 55 and older don’t have any retirement nest egg or even a traditional pension plan. Those who do have retirement funds don’t have enough money: 55 to 64-year-olds have an average of $104,000 and those 65 to 74 have $148,000 in savings

Aside from this lone anomaly, we see pretty well-defined growth in average IRA balances as age increases. Pre-retirees generally have well over $100,000 in their IRA, while Americans in the 65-69 age range have over $212,000.

Now these averages are not the most accurate gage because of the amount of wealth held by the super-rich, see the chart below.

 

 

The simple answer to question number 1 is boomer’s mandatory retirement withdrawals should have little effect on asset management companies. In fact, they could be a good long-term investment. One factor that has clause Generation X and millennials to delay purchasing a home was due to the housing crisis, perhaps they will save more for retirement after watching their parents delay or struggle in retirement.

Some additional research

Social Security benefits are much more modest than many people realize; the average Social Security retirement benefit in June 2016 was about $1,350 a month, or a bit over $16,000 a year.

For someone who worked all of his or her adult life at average earnings and retires at age 65 in 2016, Social Security benefits replace about 39 percent of past earnings. For 61 percent of elderly beneficiaries, Social Security provides the majority of their cash income. For 33 percent of them, it provides 90 percent or more of their income.

Social Security is a particularly important source of income for groups with low earnings and less opportunity to save and earn pensions, including African-Americans and Latinos. Social Security represents 90 percent or more of income for 41 percent of Asian Americans, 45 percent of African-Americans, and 52 percent of Latinos, compared with 32 percent of whites.

The answer to question number 2, the majority of retirement funds in North America will be used to cover living expenses.

In my humble opinion, a retirement crisis is coming because we are living longer and saving less. Social Security is funded by two trust funds, one for retiree benefits and one for disability benefits. The 2034 date is the exhaustion date for both funds when combined. But if considered separately, the old-age fund will be exhausted by 2035, after which it would be able to pay just 77% of benefits.

Two ways to get answers to your financial questions: send me an email (ricodilello@rogers.com) or post a comment on my Financial Question and Answer page.

 

Rising U.S. mortgage rates could be exported to Canada & even Europe

Why has the U.S. 15 yr. and 30 yr. fix mortgage rates gone up half a percent?

You can blame President-elect Trump who promised to reduce the corporate income tax from 35% to 15%, reduce the tax on repatriated profits from abroad from 35% to 10% and reductions in personal income tax rates. This clearly points to substantial federal deficits. The economic laws of supply and demand apply to bonds. Increasing the supply of bonds being sold results in bond prices going down and yields going up. The bond market has already reacted by selling off on expectations of higher deficits and more bonds coming to market.

Now the average Canadian homeowner whose mortgage comes up for renewal in 2017 may not understand why fix mortgage rates are on the rise. After all, the Bank of Canada decision last Wednesday was to hold the overnight lending rate at one half per cent. This rate has remained unchanged since July 2015. Market watchers believe that the Bank of Canada will not follow the Fed in raising rates in 2017 due to slower than expected economic growth in Canada.

The problem is higher bond yields in the U.S. has also cause a selloff in Canadian and European bonds. Some money has moved from Canadian bonds to the United States. Since fix rate mortgages are closely tied to bond yields, mortgage rates in Canada could also be on the rise. Some banks like the Royal Bank has already raised some mortgage rates.

The Royal Bank changes affect new customers with fixed rate loans for terms of three, four and five years. The fixed rate for three years rises from 2.69 per cent to 2.79 per cent, four years goes from 2.79 per cent to 2.89 per cent and five years rises from 2.94 per cent to 3.04 per cent Nov 15, 2016

Is this only temporary or is it the start of higher mortgage rates to come?

My big concern is that the bond selloff could continue. It really boils down to Trump’s agenda during his first hundred days in office. Will the fiscal stimulus for infrastructure, between $500 Billion and $1 Trillion, be passed early in the Trump administration? Where will that money come from, selling more bonds?

It appears the Fed is behind the curve regarding interest rates. Bond investors have already pushed interest rates half a point higher but the Fed is expected to raise rates by only a quarter point next week. Will they try to catch up or even change their views about keeping short-term rates lower for longer?

Be aware, higher U.S. bond yields could have a far reaching effect beyond just U.S. mortgage rates.