2017 promises to be an interesting year on many fronts and for many reasons. The most obvious being that the United States of America has a new President and Commander in Chief. While this is not intended to be a political commentary, the policies of politicians do impact the capital markets – that includes interest rates.
One can be sure that economists will be paying close attention to the new administration and how it implements policies designed to “Make America Great Again” and how these policies will impact inflation and ultimately interest rates (on both sides of the border). One thing is certain, we are entering interesting times. While some economists are polishing their spreadsheets (and crystal balls), others have noticed how financial stocks have performed since Trump won the election. Notice how the slope steepens after the US elections.
Some pundits would suggest that the steepening of the slopes is caused by an increase in the probability of interest rates moving up. To understand why this is important, we must take a moment to examine the banking sector. Banks generate their revenue by providing a variety of products and services (e.g., Personal Banking, Wealth Management, Capital Markets, Deposits and Loans…). Deposits and loans are grouped together because they are linked (like two sides of the same coin). All else being equal, the larger the difference between them, the more revenue the bank is able to generate. Think of it as a bank’s Margin.
It is well know that as the rates move lower, managing the Margin becomes difficult and it eventually starts shrinking because the banks want to avoid negative interest rates on deposits. Economists regularly confirm that we have been in this type of environment for some time and the equity markets are aware of this phenomenon. Some would even suggest that the various fees that have been introduced by banks are an attempt to replace the revenue lost from a shrinking Margin thanks to the prolonged period of low interest rates.
The charts above represent the financial services index (ETF). The first represents the US financial sector and the second the Canadian. In both cases, the positive slope steepened once Trump was elected. The suggested reasons for this includes: 1) Trump stating that he wants to reduce bank regulation and 2) The belief that Trump will make rates move higher faster if he acts on his promises.
Put another way, the stock market seems to be optimistic about the future fortunes of the banking sector. This suggests that the sector is expected to generate profits more efficiently (e.g. increase in the Margin). As stated above, because rates are at historic lows, the Margin cannot increase by reducing deposit rates (that would leave us with negative rates). It can, however, increase in one of two ways:
· Deposit rates stay static and lending rates rise
· Deposit rates rise but lending rates rise faster
While I am not suggesting that rates will suddenly rise, I do want to highlight that the US Fed raised their target funds rate in December 2016, as it was signaling. This was the second hike since June, 2006 (rate in 2006 was 5.25%). With this rate hike, I will be paying close attention to economic data to see if the inflationary pressures begin to bubble. Real estate owners should do the same and try to assess their ability to withstand rate hikes in Canada.
A recent article discussing the Margin appeared in the Financial Post.
What does this mean for people that own real estate? The short answer is to be pro-active. A typical commercial real estate loan takes several months to negotiate, secure and fund. Owners of real estate that have mortgages maturing need to begin the process early to ensure that they have sufficient time to properly analyze their options and negotiate a competitive deal. While three months is a comfortable runway for securing a mortgage, we recommend that the Borrower begin considering their options earlier and to not underestimate the value of a good mortgage broker that has both experience in commercial real estate financing as well as the right network of lenders.
Written by: Steve Giagkou, MBA, CFA | Vice President | Broker
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