1-on-1 With Hank Cunningham

Hank-Cunningham We have abundant respect for traders who stand the test of time. It’s so incredibly hard to be right more than you’re wrong in the financial markets—that is, right enough that you can generate consistent long-term returns. Hank is one of those people.

We spent a little time with him last week to get his take on rates and the Bank of Canada (BoC).

Here are some of the nuggets from our chat…

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On long-term interest rates…

Hank:  I don’t see much upward pressure on rates—not in the developed world. There’s no inflation to speak of. In fact, inflation continues to recede in most places if anything.

On the European debt crisis…

Hank:  The sovereign debt issue is a major problem, but it’s confined to a part of the globe where it’s not going to have a material impact on the rest of the world. Certainly not from a growth point of view.

On long-term rates one year from now…

Hank:  You’re going to see a flatter yield curve looking out a year. The spread between a 1-year mortgage and a 5-year mortgage is going to be a lot narrower. The yield curve is still steep right now. I think (mortgage) clients are still better off floating than they are fixing.

One of the other things you have to think about is the amount of debt coming due by governments. The U.S. has 40% of its debt maturing in the next three years. They don’t want higher inflation and interest rates.

On inflation risk…

Hank:  Inflation is just under 2% in Canada. In the U.S. it's under 1% actually.

There are 21 central banks with anti-inflation targets that are embedded in their legislation. You know they’re going to raise rates to beat back inflation and demand.  It almost defeats inflation before it starts. If the market sees central bankers acting aggressively to control inflation, the long end of the (yield) curve will come down. It becomes a self-fulfilling prophesy.

The good news is that, if inflation does become a problem, the Bank of Canada will accelerate increases in the overnight rate and dampen demand, which is actually bullish for bonds long-term because investors see that the Bank is going to fight inflation.

The 5-year rate might go up a bit, but the market will get anticipatory (and discount the Bank of Canada’s future rate increases)…and then, longer-term yields should come back down. People tend to underestimate the discounting nature of the market.

On a 2.40% to 2.50% floor in bond yields…

Hank:  That's going to be huge resistance for price—or support for yields—whichever way you want to look at it. I really can’t envision a situation for yields to drop below 2.40% for five years. This is probably as cheap as rates are going to be.

On economists’ forecasts of the Bank of Canada…

Hank:  Economists generally do straight line forecasting. They don’t allow a lot of room for (unexpected) changes in the marketplace. Rate forecasts depend on your view of the world. My view of the world is one of growth with very little inflation. In that scenario there is no need for serious tightening. Market rates will rise if the demand for money rises. The market really acts independently from the Bank of Canada, as you know.

On where we go from here…

Hank:  The BoC has already indicated that rates are going up. It (the hike in June) won’t be the last increase in the Bank rate. You’re going to see a flatter yield curve for sure.

The banks have been funding longer-term mortgages with short-term money. They pay nothing on savings and charge 4% for a mortgage. It’s been easy arbitrage. In 12-18 months that will be over.

In the meantime, people with mortgages will be “forced” to fix at the wrong time, right before rates come back down again. It happens, and it’s going to happen again. We’ve already had one false move in rates.

On going fixed or variable…

Money has been cheap. If people have fear of rates rising, you can fix right now and still have cheap money. I have no problem recommending that. But if you’re playing it close to the chest, I would stay floating right now.

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About Hank:  Hank Cunningham is the Fixed Income Strategist at Odlum Brown. Hank has more than 40 years of experience in fixed income markets. He has been a trader, institutional salesman, portfolio manager, and zero coupon specialist. Since 1988, he has specialized in the retail aspect of the investment business, building and managing three different retail fixed income trading desks for Dean Witter Canada, First Marathon Securities, and Blackmont Capital.

Hank is the author of "In Your Best Interest: the Ultimate Guide to the Canadian Bond Market" and a frequent guest on the Business News Network. (You can view his latest June 7 appearance by clicking here.)

  1. Hank is probably dead on about inflation being under control. Central banks can’t afford runaway prices and rising rates. Otherwise the cost of running a country becomes prohibiting. As Hank says, this should bode well for variable mortgages.

  2. I don’t get it.
    First, I can’t tell what “rates” he is referring to. Sometimes it seems he is talking about Prime, which is set by the BoC, and at other times it seems he is talking about fixed rates, which are set by the market. The two can’t be treated as synonymous.
    Second, on one hand Hank says, “I don’t see much upward pressure on rates—not in the developed world.”.
    But on the other hand he says, “One of the other things you have to think about is the amount of debt coming due by governments. The U.S. has 40% of its debt maturing in the next three years . . . [and] . . . You know they’re [the banks] going to raise rates to beat back inflation and demand.”
    He also notes: “The BoC has already indicated that rates are going up. It (the hike in June) won’t be the last increase in the Bank rate.”
    So, despite the fact that the Bank is currently raising rates to prevent inflation, and that he foresees them having to raise rates even higher in the near future to beat inflation when the enormous government debts come due, he sees no upward pressure on rates?
    Huh? Are we talking about the same kinds of rates here?
    And whether or not rate hikes eventually result in rate declines because of markets, doesn’t negate the fact that rates have gone up in the first place, does it?
    What am I missing here?

  3. So, how do the Western central banks react to global inflation pressures due to rising wages in China? Will they be forced to raise rates and destroy local employment rates in the process?

  4. Hi Bob,
    Great questions. Thank you!
    There are two types of rates– which you accurately point out: long-term rates and short-term rates.
    Long-term rates refer to longer-maturity bonds, which affect things like 5-year mortgages. Conversely, short-term rates impact things like variable and 1-year fixed mortgages.
    When Hank says “I don’t see much upward pressure on rates,” he refers to long-term interest rates… (per the heading above his statement)
    The statement “You know they’re going to raise rates to beat back inflation and demand,” refers to short-term rates. In other words, the Bank of Canada sets policy by raising it’s overnight rate, which immediately impacts all other short-term rates.
    Long-term and short-term rates are different animals. If short-term rate increases succesfully abate inflation then long term-rates can actually come down because of heightened confidence that inflation will remain low. (Inflation is the biggest threat to long-term bonds, which is why investors demand that inflation be kept in check.)
    Hope this helps a bit. Cheers…
    Rob

  5. Thanks Rob,
    Right, exactly.
    I know it is hard to keep things consistent when extracting snippets from interviews, but it is worth noting that in most passages he mixes comments about short and long term rates without qualifying them. It is probably the case that people with more background can simply parse these without noticing, but it is a bit inconsistent for others.
    For example: his comments referring to short term rates (i.e., “you know they’re going to raise rates to beat back inflation and demand”) is listed under a heading of “On inflation risk and long-term rates
    Thanks again.

  6. Agree 100% that Euro hype is way overblown. Prime is going up and Europe’s problems won’t prevent that.
    Then again, I doubt prime rate will jump high enough to make a 5 year fixed mortgage a good alternative.

  7. Hi Mike,
    Thanks for the note. My first advice would be to find another lender if you decide to go variable–assuming you’re fully qualified. Good variable rates are 2.00% or below at the moment.
    Secondly, you’ll want to ask your mortgage advisor to run an amortization analysis of these two options, based on future rate assumptions (i.e. based on prime rate increasing).
    Thirdly, if you end up leaning towards a variable-rate mortgage, have your mortgage advisor compare it to a 1-year fixed. Depending on future rate assumptions, you might find the 1-year to be the better bet in a rising rate environment.
    Last but not least, look at how rates have moved coming out of past recessions, and evaluate your risk tolerance for potential 2-4% rate increases (this is not our prediction, just something you should be prepared for).
    Cheers,
    Rob

  8. Debating whether I should get 3.69% 5yrs fixed or 1.9% closed variable… If the difference is only 1.79%, is it better to go with closed fixed?

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