How a higher cost of capital could reshape markets, economies

The impact of higher interest rates is often slow in reaching across far corners of the global economy, but those impacts can be seismic. The cost of borrowing can change the economic calculus for businesses, consumers, investors, and governments as the core input of capitalism, capital itself, grows more costly. While the latest rise in bond yields may not represent a reset on the scale seen after the COVID-19 pandemic, its impacts will still be felt.

David Stonehouse, Senior Vice-President and Head of North American and Specialty Investments at AGF Investments Inc., explained how he expects higher interest rates to impact the US and Canadian economies. He outlined what other forces may compete with high capital costs to keep economic trends on track and how advisors can plan for and message around this moment.

“We had a massive reset [in 2022] and it had an impact at the time, but since then we’ve been range bound. Now we’re breaking out,” Stonehouse says. “The world adjusted to a new interest rate environment four years ago, so I don’t think we’re seeing a delayed reaction to what happened four or five years ago. There are a lot of people who think that inflation comes in waves, citing the 1970s as an example. We could be going through another aspect of that where we had the first wave five years ago and we have the second wave now.”

What’s driving bond yields?

Stonehouse takes a multifaceted view of yield drivers now, noting that while high energy prices are a factor in the higher rate environment a fall in energy prices “won’t fix everything.” He notes that the government bond yields that should be most impacted by energy prices would be inflation breakevens, but those bonds have been quite range bound. If energy-driven inflation was the extent of the problem, then longer-dated bonds would see higher breakevens.

Stonehouse says that while energy prices are a factor, high debt levels and strong GDP growth in the United States are significant factors. Real US GDP growth is around three per cent and nominal growth is around six per cent. He adds that this growth is being driven in large part by a large amount of investment and capital expenditure, which tends to drive bond yields higher.

Global bond markets are also contributing. Worsening debt crises in France, the UK, and Japan all contribute to the shape of global bond markets and the yields on key instruments like the US 10-year treasury bond. The fifth factor that Stonehouse identifies is the relatively low starting point for term premium. Despite a big move up in 2022, term premium was not fully normalized until more recently. Now, finally, longer-term yields are moving higher.

The sixth and final factor driving bond yields, Stonehouse says, is the AI buildout. The scale of borrowing now being undertaken by the hyperscaling AI companies has created a competition for capital which has driven up credit and bond yields on the longer end of the curve.

What high rates mean for consumers, businesses, government

Stonehouse explains that this new rise in interest rates is coming as many borrowers who had locked in low rate financing before the end of the pandemic have been forced to refinance. Corporations that issued debt with five and ten year terms are now renewing. Canadian homebuyers are facing renewals from their five-year term loans. Even US homebuyers are forced into higher rate mortgages despite the availability of 30-year fixed term loans, simply by the natural churn and movement of people.

For consumers, higher rates mean a pullback on other spending. Stonehouse notes that many US and Canadian consumers lack a strong wealth or savings cushion to deal with this cost. Higher net worth consumers may do well on their income investments, but the lower earning echelons now face harder choices. He notes the continued low volume of transactions in the US housing market as signs of this new rate regime having an impact. In Canada the housing market has continued to fall despite lower rates relative to the US, something Stonehouse attributes to shorter renewal terms and more acute consumer sensitivity.

Looking at the US government, Stonehouse says it has been resistant to the rise of interest rates but not immune. The US has refinanced its debt with T-bills over the past few years, and the yields have stayed in a 5.25 to 3.75 per cent range. AI debt issuance, too, hasn’t been derailed by high borrowing costs. Companies building AI infrastructure are still more motivated by existential competitive risk than managing the cost of debt.

Higher cost of capital also disincentivizes some shareholder-friendly behaviour on the part of publicly traded companies. Higher cost of capital means companies are more likely to spend on R&D and growth-generating enterprises rather than share buybacks and dividends. Stonehouse says we’ve seen some of that play out, but that the largest technology companies are still engaging in significant share buybacks.

What all this means for Canadian investors, advisors

Despite a poor year for fixed income investors, Stonehouse is quick to emphasize that the relatively higher starting point in yields as well as the income cushion those yields provide should offset any sense that we’re repeating the 2022 bear market. Looking at equity markets, he notes that a high cost of capital and the uncertainty that causes it has also resulted in multiple compression. Profits remain high among S&P 500 companies, but share prices aren’t moving up as rapidly. Investors are discounting earnings against those high capital costs.

Stonehouse says this can be most acutely felt in less profitable, smaller-cap, more levered companies. Small caps have struggled in the past few months, he says, largely due to this rate overhang.

There are silver linings in the bond market for Stonehouse. He notes that yields are now high relative to their 20-year norm, and that a slowdown in nominal GDP growth as a result of high energy prices or high interest rates themselves could result in a pickup in bond prices. He reiterates how challenging the inflation backdrop is in the United States, and that a growth deceleration may be likely even if a recession is not in his base case.

“We would still be encouraging investors to stay the course. It’s been a bit of a challenging environment, but as long as it doesn’t continue, as long as yields don’t continue increasing at a rapid rate, and we do think they’re getting closer to a more attractive sustainable level, then we would anticipate that the setup is actually fairly attractive for investors to step in here given the correction that we’ve seen in bonds and a lot of the stock market.”