A matter of interest

The decision depends on the outlook for rates

BRENDA DALGLISH February 15 1993

A matter of interest

The decision depends on the outlook for rates

BRENDA DALGLISH February 15 1993

A matter of interest

The decision depends on the outlook for rates

The first step for most investors, as the 1993 Registered Retirement Savings Plan (RRSP) season unfolds, is to consider the perplexing question of the future direction of interest rates. Making the right guess about them, and then choosing the type of investment that does best in that interest rate environment, often have more impact on an investor’s yearly return than specific decisions about which particular stocks, bonds or guaranteed investment certificates to buy.

As usual, this year’s rate forecasts are mixed. But opinions have tended to congregate in two camps. One group of forecasters say that they believe that inflation will remain low and that the economy will grow only slightly faster in 1993 than it did in 1992, when the growth was almost invisible. As a result, they say, interest rates will continue to move lower. The second group, though few in number and contrarian by nature, are challenging conventional wisdom with the prediction that the economy will surprise the experts in 1993 and rates will be climbing back up by the end of the year. Maclean’s presents the arguments for both sides of the interest rate debate.


The argument that interest rates will continue to fall has been gathering momentum for more than two years.

Indeed, many fundamental economic indicators recently seem to be flashing signals to support that case.

Many prices—including interest rates, or the price of borrowed money—have stabilized and, in some cases, begun to fall. When Ford Motor Co. of Canada introduced its 1993 models last fall, it announced that for the first time since the Second World War the average price would be lower than the year before. Real estate values have also plunged—with the exception of a few choice havens, such as Vancouver. Canada now has the lowest inflation rate of all the industrialized countries. The Bank of Nova Scotia summed up the new economic environment in its 1993 global economic outlook report: “Deflation—not inflation—is now the greatest risk.”

The view that inflation and interest rates will stay low is based on the expectation that the economy will grow only modestly in the coming year, with an increase in the gross domestic product of about three per cent, compared to

the less than two-per-cent rate estimated for 1992. With so many companies now operating far below capacity, that growth will not create much employment growth or price inflation.

In such an economic environment, most investment advisers are forecasting a prolonged period of low inflation and, as'a result, a downward trend in interest rates. RBC Dominion Securities Inc., Canada’s largest investment dealer, declared in its latest quarterly report on the North American investment outlook: “The past four years of strong-arm monetary policy in Canada and slow or slowing growth around the world should guard against rising prices.” The report added that “similar to the delayed response to falling inflation in the 1980s, investors should begin to accept a lower real rate as they slowly recognize” that the risk of rampant inflation is no longer likely. For his part, Toronto investment adviser Thomas Delaney, of T. Delaney Inc., said: “We are looking at inflation rates in the range of 1.5 per cent to two per cent not just for the next two or three years but well into the next millennium.” He added: “A couple of years down the road, today’s interest rate of 7.5 per cent on five-

FUND: Jarislowsky Finsco Funds


STRATEGY FOR 1993: Sell Canadian bonds short and buy companies that are involved globally, as well as companies that do well in recessionary times, including liquor, tobacco and food companies

BEST CALL IN 1992: The fall of the Canadian dollar

WORST CALL IN 1992: There are too many to name. But PWA Corp. was one of the worst.

year money is going to look pretty good.” Already, in this business cycle, short-term interest rates have fallen from May, 1990, when the central bank rate peaked at more than 14 per cent, to September, 1992, when it edged down to just under five per cent. Longterm rates have also declined, from a high of about 11.5 per cent three years ago to about 8.5 per cent currently. But long-term rates, generally those for a period of five years or more, tend not to have fallen as dramatically as

short-term ones mainly because of persistent investor fears that inflation is not truly dead. And real after-inflation, long-term interest rates are extremely high. Real rates are now close to seven per cent, more than double their historical level. In the past five months, political uncertainty and economic weakness have caused interest rates to fluctuate, increasing concerns about the potential for future rate declines.

However, some experts say that they think that the political uncertainty about Canada’s future is now fully reflected in a lower Canadian dollar and higher interest rates and that political uncertainty is no longer much of a threat to stability—despite the upcoming federal election and lingering concern surrounding the health of Quebec Premier Robert Bourassa. Rates are already high, and in the last year the Canadian dollar has fallen 10 cents to about 79 cents (U.S.). Said Willard Sutherland, bond mutual fund manager for Altamira Investment Services Inc. in Toronto: “Our problems are well documented, everyone knows them and the fear is reflected in the high [real] rates.” He added: “We have come to the point where we cannot think of anything else that can go wrong with Canada.” In addition, late last week Germany and Japan lowered their bank rates, a trend that economists say will also help bring Canadian interest rates down.

In the longer term, some observers say that the demand for credit will gradually diminish during the rest of the decade as debt-burdened consumers, companies and governments reduce their borrowing. Said Sutherland: “In the 1980s, households borrowed too much for real estate, corporations borrowed too much for

assets and we don’t even have to mention governments. But now, everyone realizes that they borrowed too much and debt is going to get paid down. We are not living in the 1980s’ borrowing fantasyland.” And as the demand for borrowed money eases, the theory goes, interest rates will come down.

If true, for investors a continued move to lower interest rates means that the current rates on such investments as long-term guaranteed investment certificates are higher now than they will be in a couple of years; that the bond market, which offers the greatest potential for capital gains when interest rates are falling, could turn in strong investment gains before it levels off; and that in the lower interest rate environment, corporate Canada will find it easier to make profits, which should push the lagging Canadian stock market into a rally. As a result, investors could profit from careful investments in any of those types of investments.


One Friday afternoon last month, Gordon Capital Corp., a secretive Toronto securities firm, fired all 15 members of its bond-trading department. The company declined to explain the move, but initial reports suggested that the department closed down because of trading losses and other business problems. Now, other industry insiders speculate that there is another explanation for the department’s demise. They suggest that, like sophisticated investors who are now selling their bonds because they think interest rates have hit bottom, and bonds offer the greatest potential for gains when interest rates are falling, Gordon simply decided that interest rates are about as low as they are going to get and dumped its traders.

Whatever Gordon’s real motivations, the view that interest rates have no more room to fall, and that they may even soon start climbing again as the recovery gains steam, is gaining credence. If the U.S. and Canadian economies were to surprise the forecasters, as they have done for the past three years, and grow somewhat faster than expected, the central banks would tighten money supply and push up interest rates. Jeffrey Rubin, chief economist of Wood Gundy Inc. in Toronto, says that his forecast calls for Canada’s gross domestic product to grow by 3.8 per cent this year and for interest rates to edge slightly higher by the end of the year. Added Rubin: “I am very bullish about the economy.”

George Pedersson, an independent economist who heads his own firm, G. A. Pedersson & Assoc, in Vancouver, is even more adamant that the economic surprise of the coming year is going to be the strength of the economic recovery in Canada and the United States. “The consumer is feeling better,” said Pedersson. “Companies have cut their costs, the dollar is down, which helps exporters, people feel a lot more comfortable about their jobs. The risks are more on the up-side than the down.” He added that he expects short-term rates in Canada to climb as high as nine per cent by the end of the year. As for all the cautious forecasts predicting continued slow growth, Pedersson noted that “recoveries always take forecasters by surprise.”

Predictions of higher rates also receive support from a second, unrelated and much more worrisome scenario: political events could force them up. Economic forecasters say that Canada’s federal and provincial budget deficits



• March 1,1993, is the last date to make a 1992 contribution. 0


o • 18 per cent of earned income to a maximum of $12,500 (less a pension o


adjustment—the amount that the employee and employer contribute to a pension plan) for the 1992 and 1993 tax years. That will increase ° to $13,500 for 1994, $14,500 for 1995 and $15,500 for 1996.

• The limit is based on the previous year’s earnings.


• The highest wage earner in a family can choose to put some or all of his ° contribution limit for the year in a spousal RRSP, allowing couples to minimize future taxes by averaging incomes.

• Contributions to an RRSP for a common-law spouse are now permitted.

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• Interest-bearing securities including guaranteed income certificates, bonds, mutual funds and individual stocks.


• For 1992, up to 16 per cent of an RRSP can be invested abroad. This rises to 18 per cent for 1993 and 20 per cent for 1994 and subsequent years.


• Beginning with 1991 contributions, individuals can carry forward unused RRSP contributions for seven years.

• A contribution is deductible against the income in the year it is made, not against income in the missed year.


° • An individual can over-contribute up to $8,000, throughout his lifetime, o to an RRSP without penalty. The $8,000 limit is intended for use as a cushion for excess contributions.

• Anyone exceeding the limit will have to pay a fine of one per cent per month on the excess amount.

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• RRSP funds are allowed to compound tax-free inside a plan. When they ° are withdrawn, they become fully taxable, o • All RRSP plans must be wound down by the end of the year in which the 0 plan owner turns 71.




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will continue to grow, forcing interest rates to stay high to attract enough foreign investment to keep adequate funds coming into the economy. Said Martin Barnes, managing editor of the Montreal-based Bank Credit Analyst “We have an election coming this year from which we could end up with a coalition government or some kind of muddy, unclear political outcome. In that environment, we are not likely going to see any big action to cut the deficit.” He added: “The danger is that foreigners will decide that they have had enough of this country.” If that happens, interest rates could soar, making interest-sensitive investments, but not the stock market, more attractive. Added bond manager Sutherland: “My biggest fear is that

the economy will continue to deteriorate and then the governments will be forced into paying whatever it takes. If they need the money, they will pay 11, 12, 15 per cent, there is no limit.”

Economists broadly agree that a weak economy, accompanied by a prolonged surge in interest rates, would almost certainly guarantee that the economy would slide back into recession. But it might also provide an opportunity for Gordon Capital to re-enter the bond trading business—in the hope of eventually enjoying a lucrative toboggan ride down the slope of falling rates.