Could Rates Go Lower?

Could we see lower interest rates? On the surface it seems counterintuitive with North American rates near zero and a Federal Reserve on a track to normalization. But with some industrialized economies – notably Switzerland, Germany and Japan – issuing debt with negative rates, near zero is beginning to look like the best game in town.

We are seeing major institutional investors putting money to work in Canadian and US Treasuries which is propping up bond prices and reducing yields. Not so much on the short end but in the ten to twenty year maturity spectrum which is causing the yield curve to flatten. The point is we could see lower rates despite upward intervention by the Bank of Canada and the US Federal Reserve.

The challenge is putting money to work in sectors that will benefit from lower rates. That’s easier said than done because we find ourselves in uncharted territory. We are not in an environment where lower rates are likely to stimulate demand. It has not had the desired effect in Europe or Japan and so far has been a non-event on this sides of the pond.

Based on history, we can assume lower rates will have a negative impact on the banking sector. Banks lend long and borrow short. A flat yield curve leaves no margin. This environment is particularly painful for US money center banks which continue to operate under tough government regulations.

Canadian banks are in a better position because they are playing under well-established rules, are well-capitalized, hold decent mortgage portfolios and assuming oil prices stabilize, will not have to increase loan loss reserves for exposure to the Canadian oil patch.

History suggests that highly leveraged companies benefit in a low interest rate environment. Assuming they can borrow at prime. Much depends on whether they are operating in a sector with decent prospects. For example, oil companies have significant leverage which is highly beneficial when oil is above US $70 per barrel. Not so much at US $50 per barrel.

Airlines also carry a lot of leverage but unlike oil companies, are in a period of healthy passenger volumes and solid profit margins. Management can anticipate reduced carrying charges when financing fleet upgrades. Low oil prices coupled with more efficient engines in an upgraded fleet help manage expenses. Bottom line over the short to medium term everything seems to be going right for this volatile sector. Longer term be mindful of higher fuel prices and increased wage demands from unionized workers.

Historically low interest rates should be good for commodities. Notably gold which has a cost of carry attached to its price. But this time the link between interest rates and commodities has been mixed. And that’s the rub!

We are experiencing a period where there is no historical precedence which means we are making decisions in a vacuum. In such an environment you have to work with what we know to be true.

To that point the cost of money has a defined impact on option premiums. More specifically the difference between the risk free rate of interest and dividends – if any – paid by the underlying security impacts the value of calls relative to puts. Admittedly the cost of capital is not as important as volatility, but that can be an advantage if we are able to collect better than average premiums when volatility expands, and can do so in an environment where the cost of money is declining.

You may discover that selling low risk covered or cash secured options is the best strategy in an unprecedented environment.