Milan Cacic
July 26, 2024
Money Financial literacy Economy Commentary Trending Weekly update Weekly commentaryBANK OF CANADA CUTS AGAIN!
On Wednesday, the Bank of Canada cut its key interest rate by 0.25% for the second time. The Bank of Canada rate now stands at 4.5%, which is 50 basis points (0.50%) below where it was at the beginning of June. The governor of the Bank of Canada, Tiff Macklem, also stated that it would be reasonable to expect further rate cuts if inflation continues to ease. If you're wondering why the Bank of Canada is cutting rates, just take a look at the chart below.
As you can see, the below chart indicates that the Canadian CPI (excluding shelter) has been dropping like a rock and fell below 2% last month. The economy in Canada is slowing and inflation is decelerating quickly. As the governor stated, it is likely more rate cuts will follow. So, the question we should ask ourselves is "what happens to different asset classes when interest rates start coming down?”
Interest-sensitive stocks can benefit from declining interest rates. The chart below shows us that dividend-paying stocks have outperformed significantly in past rate-cut environments. There are two reasons this happens:
- When interest rates come down, interest expenses for these companies come down. Think about a large pipeline company or utilities company that has significant amounts of debt on the balance sheet. Every time interest rates get cut, the amount of interest they have to pay on their debt goes down. All of the savings from lower interest payments go from an expense directly to earnings.
- As interest rates fall, people will require comparatively smaller dividend yields from companies that they own. Imagine the market requires a company to pay them a 6% dividend to own their stock in the current interest-rate environment. If interest rates start to come down, and the market therefore accepts that a 5% dividend yield on the stock is good enough, the stock has to go up 20% to make the dividend go from 6% to 5%.
For easy math, let’s use a $100 stock paying a $6 dividend:
$6 dividend / $100 stock price = 6% dividend
The stock price would have to increase to $120 in order for that same $6 dividend to be worth 5%:
$6 dividend / $120 stock price = 5% dividend
I have also included a piece from our CIBC economics team entitled “Shoulda woulda coulda”.
As always, if you have any questions, please feel free to give us a call at any time.
Have a great weekend.
Milan