In the famous but rephrased words of Etta James, “At last, rate cuts have come along.” Last week, the Bank of Canada (BoC) announced its first rate cut since 2020, reducing the overnight rate to 4.75%, the first among the G7 countries to do so.
With this welcomed news, the change in monetary policy will have ripple effects on various asset classes and business sectors of the economy. This article will highlight the possible changes this and ensuing rate cuts may have on the investment landscape and the ETF solutions investors can utilize during this economic inflection point.
Why did the Bank of Canada (BoC) cut interest rates?
As stated in the press release accompanying the announcement, the growth in the Canadian economy for the first quarter of 2024 and the easing of inflation, alongside other positive economic trends, provided the BoC Governing Council with a strong sense of confidence in their decision to reduce the policy interest rate by 25 basis points.
While the inflation outlook remains positive and the BoC believes it will continue to trend downward, the Governing Council will remain vigilant of changes in the economic landscape.
Canadian ETFs to consider following the BoC rate cuts
The reduction in the policy interest rate directly impacts fixed-income instruments. With the inverse relationship between bond yields and price, the current scenario presents a potentially profitable opportunity for bond buyers. In previous years, the lower rates and yields left little income or embedded yield to offset negative price moves. This led to negative price returns, primarily due to rising rates.
With the BoC being at the beginning of its rate reduction actions, bond prices will appreciate as further reductions are implemented. A Bloomberg report on the day the announcement occurred stated that bonds rallied after the cut, and yields on the government of Canada's 2-year note fell 10 basis points as of 11:25 a.m.
Bond ETFs to consider
For investors seeking fixed-income solutions that may benefit from the reduction in interest rates, exploring Canadian government bond ETFs or Canadian aggregate bond ETFs could be a strong starting point.
In the case of Canadian government bond ETFs, the iShares Canadian Government Bond Index ETF (Ticker: XGB), Franklin Canadian Government Bond Fund (Ticker: FGOV), and Mackenzie Canadian Government Bond Index ETF (Ticker: QLB) all provide comprehensive Canadian government bond exposure, investing primarily in bonds issued by Canadian federal, provincial and municipal governments and government agencies.
For Canadian aggregate bond exposure, the BMO (TSX:BMO) Bond Aggregate Bond Index ETF (Ticker: ZAG), Vanguard Canadian Aggregate Bond Index ETF (Ticker: VAB), and Mackenzie Canadian Aggregate Bond Index ETF (Ticker: QBB) all provide a broad measure of the Canadian investment-grade fixed income market consisting of Government of Canada, Provincial and Corporate bonds.
Bank and Financial sector ETFs to consider
The elevated interest rate environment placed a strong focus on banking institutions, particularly on their reporting of Provision for Credit Losses (PCL), an expense set aside by financial institutions to cover potential losses on loans, credit exposures, and other financial instruments.
While there is no certainty as to how quickly borrowing costs will fall as further reductions in the policy rate occur, it is reasonable to assume that consumer financing affordability will improve over time, resulting in banks reducing the money set aside for PCL.
Though higher borrowing costs boost interest income for the big lenders, a broad recovery in consumer affordability and lower rates are expected to be additive to banking performance.
Simply put, with interest rates potentially moving lower in 2024, the tailwinds of stable to lower funding costs, borrower alleviation, and improving capital levels should be enough to propel banking stocks forward.
For investors that desire to have broad exposure to Canadian Banks and/or the Canadian financial services sector at large, the iShares Equal Weight Banc&Lfco ETF Comm (Ticker: CEW), BMO Equal Weight Banks ETF (Ticker: ZEB), Global X Equal Weight Canada Banks ETF (Ticker: HBNK), iShares S&P/TSX Capped Financials ETF (Ticker: XFN), and Global X S&P/TSX Capped Financials ETF (Ticker: HXF) are worth consideration.
While ZEB and HBNK both provide exposure equal weight exposure to the Big Six Canadian banks, the former invests in and holds the constituent securities of the Solactive Equal Weight Canada Banks Index in the same proportion as they are reflected in the index, whereas the latter holds the index directly.
CEW provides investors with diversified equal weighted investments in the largest Canadian banks and Canadian life insurance companies. CEW will endeavor to provide holders of its Units with monthly cash distributions. Both XFN and HXF provide investors with exposure to the S&P/TSX Capped Financials Index.
The potential for monetary policy divergence
The day following the BoC announcement, the European Central Bank (ECB) lowered its key deposit rate by a quarter-point to 3.75%. As stated in the accompanying press release, since the Governing Council meeting in September 2023, inflation has fallen by more than 2.5 percentage points and the inflation outlook has improved markedly.
Underlying inflation has also eased, reinforcing the signs that price pressures have weakened, and inflation expectations have declined at all horizons. Monetary policy has kept financing conditions restrictive. By dampening demand and keeping inflation expectations well anchored, this has made a major contribution to bringing inflation back down.
The reduction of interest rates by both the BoC and ECB is setting the stage for monetary policy divergence, as financial subject matter experts have postulated that the U.S. Federal Open Markets Committee (FOMC) may keep rates high—with no reductions in the near term.
In a recently published report by Goldman Sachs (NYSE:GS), entitled Central Bank Divergence: Room to Run?, three monetary policy watchers—Peter Praet, former Chief Economist and Executive Board member of the ECB, Maurice Obstfeld, Professor of Economics Emeritus at UC Berkeley and former Chief Economist at the IMF, and Jan Hatzius, GS Chief Economist and Head of Global Investment Research all believe monetary divergence is likely, albeit for differing reasons.
In his statement to the media, Governor Tiff Macklem noted that monetary policy divergence from the U.S. has occurred in the past. Presently, conditions are different in both countries, as inflation has eased more in Canada while the U.S. economy has been stronger.
Takeaway
With interest rates slated to fall further, Canadian investors can position themselves to capitalize on this economic shift by investing in ETFs that provide exposure to the Canadian fixed-income asset class and financial sector.
Additionally, the divergence in monetary policy between developing economies may also present newfound opportunities; as such, remaining observant and open to taking action as new information becomes available is also encouraged at this juncture.
This content was originally published by our partners at the Canadian ETF Marketplace.