Last week, investors saw U.S. Federal Reserve chairwoman Janet Yellen raise the overnight interest rate in the United States. Although the markets moved on the news, nothing too drastic happened. Most investors sit on one of two sides: either the rate hike was overdue, or it is still too soon. We need to ask ourselves what a rate increase would mean for Canada and how we as investors can make money from this situation.
For Canadians investing in the stock market, there is a domino effect which involves a lot of different business and investment drivers. Although no rate hike has yet to be announced by the Bank of Canada, it is worth noting that the 10-year Government of Canada bond rates have increased from a yield of approximately 1% a year ago to a yield closer to 1.5%. The yield has increased by 50 basis points or by 50%, depending on how we want to look at the situation.
The first and most obvious effect the increase in rates will have is a higher cost of borrowing for Canadians who have taken on debt (both unsecured and mortgage debt). This will translate to higher revenues for Canada’s lenders. Next, higher rates could lead businesses to reconsider undertaking new projects as the higher cost to borrow may mean projects will no longer meet the higher hurdle rates.
While a decline in borrowing will not help the overall economy, it is important to understand what that means for the current profitability for any one of Canada’s lenders. As loans are paid back, the cash inflows then become available for dividends and share buybacks as less money will be required to expand the balance sheet. While a number of Canada’s big banks have an adequate divide between the payout and retention rates, the fact of the matter is that these companies may need less capital to lend out while having additional cash flows to return to shareholders.
Bank of Montreal (TSX: BMO)(NYSE: BMO) is currently trading at a very reasonable 11.5 times trailing earnings while offering investors a dividend yield close to 4%. Although investors typically don’t want to invest in a shrinking pie, the market may already be pricing in a contraction in Canada’s banking sector. Investors will have to be patient to see how Canada’s banks respond to the challenge.
The good news for the day-to-day operation of Canada’s biggest lenders will be that higher rates will lead to higher margins when considering the difference between the rate banks offer savers and what is charged to borrow money for any lending product. Although 25-50 basis points is not a lot, the reality is that 50 basis points is still 50% more than the 1% yield offered just one year ago. For long-term shareholders in Canada’s biggest banks, things may improve as we move forward.
