Estimated reading time: 8 minutes
With the Bank of Canada Interest Rate sitting at 4.00%, and GIC rates north of 5.00%, what GIC term (1 – 5 years), what is the Interest Rate Path, and what should a Condo Select for their Reserve Fund Investments?
Table of contents
Alignment of Reserve Fund and Rate Path
To determine the Interest Rate Path, first, lets step back and remember what a Reserve Fund is there to do: To have the Funds available to meet Capital Expenditures (Roofs, Windows & Doors, etc.) when required. So, in order to answer this question properly, one must have an idea of what expenditures are going to be required over the next 5 years. Where does one get this information? The Reserve Fund Study of course! This is the starting place, as it estimates the expenditures each year over the 30 year time horizon. Then, through discussion with the Board and Property Manager, we can factor in any known adjustments (maybe the Roof HAS to be done this year, instead of next, etc.)
Lets take a simple example of a Reserve Fund that has $250,000 currently, and expenditures of $50,000 each year for the next five years. Well, you may think the answer is simple $50,000 is 1/5 of $250,000, so I put 1/5 (20%) in each of a 1,2,3,4 & 5 year GIC – Right? WRONG! This simple analysis forgets one truth, I may have $250,000 right now, but over the next 5 years there will also be contributions each month to the Reserve Fund!
After we take the Current Reserve Balance, Expenditures and Contributions into account, an ideal laddered GIC Portfolio may look something like the below (but keep in mind this answer will be different for each Condo depending on their particular situation):
1 Year – 15%
2 Year – 20%
3 Year – 15%
4 Year – 10%
5 Year – 40%
So then, that must be the end of the story, right? Well, you could end there, yes – but if you really want our advice keep reading for our insights into what history tells us about the likely path of Interest Rates given the correlation to Inflation.
Remember that Interest Rates are dynamic (they change). Just like any investment, however, the future path of Interest Rates are uncertain – there are no guarantees; however, history does have some lessons.
Interest Rate Path and Inflation
Todays GIC rates of > 5.00% look quite healthy, compared to the 1.50% we were seeing only a few short months ago; but, will interest rates keep increasing, level out, or decrease? Again, the future path is uncertain, but looking at the history should offer us some clues. To understand the history, first one must understand the correlation between Interest Rates and Inflation. It shouldn’t take a math whiz when looking at the Chart above that Interest Rates and Inflation largely move in lock-step – but why? Well – you can write your whole Economics PhD thesis on this topic, but for our purposes here all you need to know is that Interest Rates are the main policy lever that Central Bankers (the Bank of Canada) use to control inflation. So when Inflation gets too high, Central Bankers increase the Interest Rate to try to lower Inflation, and when Inflation gets too low, they decrease the Interest Rate to try to increase Inflation. The Bank of Canada has a Target Inflation Rate of between 1 – 3%, and currently Inflation is at 6.88%! – hence why Interest Rates have been increasing.
So – lets ask the question again – will Interest Rates keep on increasing, level out, or decrease? Well history should offer us some clues: Over the last 50 years, there have been several periods of what we will call “Excess” Inflation: 1972-84, 1988-92, 2002-04 and 2009-11. What lesson should we learn from each of these periods? Well, if you look at each of these periods in question (with the exception of 1988-92) the Bank of Canada Interest Rate had to get ABOVE Inflation, and kept increasing interest rates and then levelled Interest Rates off, before Inflation started to actually decrease for good. Why was 1988-92 the exception where Interest Rates could decrease along with Inflation? Well, again, you could write a whole PhD on this topic, but essentially the rationale likely is that in the 1984-92 period Interest Rates were significantly above Inflation, and for a long period, which built up a sort of Inflation Insurance Policy – ie the Bank of Canada had some credibility that they could get Inflation under control by increasing Interest Rates to 15-20% in the 1980s and early 1990s
The question then comes down to, how do Central Bankers gain and maintain credibility that they can get Inflation under control? To answer this question, one needs to look no further than the 1972-1984 period. Early in this period by about 1976 the Central Bank seemingly got inflation under control, by bringing the Interest Rate (9%) above the Inflation Rate (8%), such that the Inflation rate started to decrease to almost 5% by 1978. Correspondingly, the Bank of Canada started to bring down the Interest Rate in line with Inflation. Guess what happened? Well, if you were alive during this period, I’m sure you know – Inflation came roaring back, and with a vengeance, peaking above 15% in the early 1980s. The thinking goes that essentially the Bank of Canada (and almost all other Central Banks around the world) lost credibility that they would or could tackle inflation. So the Bank of Canada had to reverse course, and get Interest Rates back above Inflation, peaking above 20% and keep them above the Inflation Rate for a longer period of time (10 years)- which comes back to our 1988-92 period above. Perhaps if Central Bankers had not decreased Interest Rates in the mid 1970s when Inflation began to decrease, and instead slowed the pace of increase and then levelled Interest Rates off until Inflation was in the Target Range, they wouldn’t have had to subsequently increase interest rates so high subsequently. Credibility takes years to earn, but is very easily broken, this is the lesson Central Bankers hopefully learned.
Ok, great – so back to our question, will Interest Rates keep increasing, level out, or decrease? Ultimately, the thinking goes, the answer depends on how much credibility you believe the Central Banks have. If you think the Central Bank has a lot of credibility, then perhaps Interest Rates could level out, or decrease soon. If not, then Interest Rates are likely to keep increasing, before leveling out. The last time Inflation was this high was was during the 1970-1980s period, and the lesson from this period likely looms large, where the Central Banks thought inflation was under control too soon, and paid a deep price.
Again, the path is uncertain, and if you have a Crystal Ball, I’m sure many investors around the world would like to know. However, at Lambda it is currently our belief that Central Bankers, including the Bank of Canada, do not necessarily feel they have credibility to declare the war on inflation over prematurely. It is likely that they will need to keep the Interest Rate above the Rate of Inflation for a period of time. Inflation is currently at 6.88% and the Bank of Canada Interest Rate is currently at 4.00%. This means that at a minimum a combination of Interest Rate Increases or Inflation decreases of approximately 3.00% are needed before the Interest Rates will likely level out. The Bank of Canada meets 9 times between now and the end of December 2023. If the Bank of Canada were to increase interest rates each meeting by 0.25% that would bring the Interest Rate to 6.25% and combined with continued decreasing Inflation from 6.88%, would likely bring the Bank to the point that the Interest Rate was above Inflation, and perhaps Interest Rates could level off there. However, remember the lesson of the 1970s and 1980s, the Bank of Canada sure does! They likely will not start decreasing Interest Rates until the Inflation rate remains in the Target 1-3% period for a period of time, maybe a year or two! And 6.88% is a long ways away from 1-3%…
What Should a Condo Do?
So then, back to the Condo Reserve Fund – what should a Condo do? The other factor to consider is what “Term Premium” do you receive? I.e. how much more Interest do you get for locking in for a longer period? Currently at Lambda we have 1 Year GICs at 5.20% and 5 Year GICs at 5.10%. Yes – you actually receive less interest for locking in for 5 years (at least in Year 1 – what happens in Years 2-4 is the question!). This is known as an Interest Rate Inversion, and is a sign that a recession is coming. But, the question remains whether Inflation will decrease to the Target Range. You certainly could have Lambda simply build an Ideal Laddered GIC Portfolio given the Reserve Balance, Expenditures and Contributions as per above. Or, you could invest all of the Reserve Funds in 1 Year GICs until we start to see Interest Rates get above Inflation for a period of time (likely at least a year), and then start to move the 1 Year GICs to the Ideal Laddered Portfolio of 1 – 5 year GICs per above. It ultimately is your decision; however, at Lambda it is our current belief that things are more like the 1970-1980s than the 1990s (and don’t even get me started on the music…)
Long story short, if you just jumped to the bottom (ya – I caught you!), it is our belief that Interest Rates are likely going to keep increasing for the next year, and then level out for a year or two, before then finally being able to decrease, and Condo Corps should therefore likely be investing more funds in 1 Year GICs than they would otherwise. But, if you do have a Crystal Ball, please let us know!