Short term interest rates

Exciting times in Canadian government interest rates – finally seeing some yields again (2 year Canada government bond chart below):

Short-duration bonds are yielding higher than they were before the 2008-2009 economic crisis. The one-year bond is at 3.67% currently, and the two-year at 3.53%.

I’ve talked about this before, but one theory in finance is regarding the term structure of the yield curve in that the total returns is invariant to the term one invests in – e.g. if you invested in 1-year government bonds 10 times, the net result will be the same as if you invested in 1 10-year bond. Of course, practice is different than theory, but if one were to take this theory and apply it with the existing rate curve, it would suggest that the target rate is going to rise significantly higher than the so-called “neutral rate” which, according to the monetary policy report, is between 2-3% nominal. I’ll leave it up to the reader to decide on the validity of these financial theories.

In the monetary policy casinomarkets, the 3-month Bankers’ Acceptance Rate is currently at 3.46% and has crept up slowly in anticipation of September 7, 2022’s expected rate increase – the September futures indicate a 3.89% 3-month rate. I am not sure if this translates into an expectation of 50 or 75bps for the September 7 meeting, but either way short term interest rates are going up. The next meeting of the bank on October 26 is anticipated to have a 25 basis point increase as well.

All of this means that money is coming harder and harder to come by. Governments will find it much more expensive to borrow money, so I would look carefully at your portfolio for entities that are government-dependent.

The big risk continues to be that interest rates will rise further than the market anticipates – and it likely will if inflation does not reach the magical 2% target.

The US dollar wrecking ball

By far and away, the largest surprise for many has been the relative strength of the US currency to the exclusion of others:

Since most international trade is denominated in US currency, it means that for foreign countries engaging in commodity purchases and most other imports, the trade currency becomes that much more expensive to transact. This has an effect on their cost inputs (in addition to the core commodity prices themselves being relatively inflated). For example, when Europe wants to import LNG, not only do they have to pay an extremely bloated premium to doing so, but right now they are dealing with record lows of “99 Euro-pennies” being equal to one US dollar.

The US Federal Reserve as well is raising interest rates, so holding cash (or liquid short-term treasury notes) is no longer a zero-yield option: indeed, you can lend your money to the US government for a year and get 3.3% for it. Cash is once again becoming more valuable.

It was widely anticipated that with inflation and the US government printing massive deficits that the currency would sink like a stone – indeed, it has gone in the opposite direction as people are demanding US dollars, especially as asset markets depreciate, and credit stress becomes apparent.

The future course of action appears to be that there will be some sort of crescendo event where the US dollar will gain so much strength and then when things break somewhere, the US dollar will be sold off. I don’t know when this will be.

All I know is that being levered long in this environment is dangerous – especially as the existing consensus is that the fed will drop interest rates again in 2023 – what if they don’t because inflation is still running well above 2%?

Prices are formed on the basis of the sentiments of the marginal bidder and marginal seller. In the event that there is an instantaneous drop in demand and consistent supply, prices will drop and they will drop quickly. As interest rates rise and central banks continue to pull capital out of the bond markets, it is like taking oxygen out of the room. Initially, nobody notices. Then there is a point where people actually feel better, despite the fact that the oxygen level gets below where it can sustainably maintain your cognitive function. We’re probably at that point in the markets. Then finally, you start to lose your functionality entirely before losing consciousness.

I’ve used the market rally that began in July to pull out the weed-wacker and trim the portfolio a little bit and raise cash. If things rise from here, I’ve got plenty of skin in the game. However, the suffocating effect of rising interest rates is increasingly apparent. It will be very difficult to generate excess returns at present.

Yellow Pages’ peculiar share buyback

Yellow Pages (TSX: Y), a long-time holding of mine, announced their second quarter results a couple weeks ago.

There were some interesting highlights involved, namely that this quarter was the first quarter in a very, very, VERY long time where they had a sequential increase in revenues between quarters (albeit, the profitability of such revenues decreased as the mix had more lower margin revenues). This got very little recognition.

The actual cash generation figures have still been quite healthy, although this is the first full year where Yellow’s tax shield has whittled away to only partially offset their income. By virtue of making some seriously questionable past acquisitions (before the belt-tightening regime of the existing management) they are allowed to deduct a declining balance amount on their cumulative eligible property, which is better than nothing.

However, the highlight is what is essentially a forced share buyback:

The Board has approved a distribution to shareholders of approximately $100 million by way of a share repurchase from all shareholders pursuant to a statutory arrangement under the Business Corporations Act ( British Columbia ). The arrangement will be effected pursuant to a plan of arrangement which provides that the Company will repurchase from shareholders pro rata an aggregate of 7,949,125 common shares at a purchase price of $12.58 per share, which represents the volume weighted average price for the five consecutive trading days ending the trading day immediately prior to August 5, 2022.

The proposal requires 2/3rds of the shareholders to approve, but they already have consent from the three major shareholders (GoldenTree with 31%, Empyrean with 24% and Canso with 23%) to proceed. Minority shareholders (such as myself) are along for the ride, although because the buyback is proportional, no entity will have a different level of ownership after the transaction (restricted share units, options, etc., typically have clauses to reflect such special distributions).

At the end of June 30, Yellow had 26,607,424 shares outstanding. This works out to a distribution of $3.76/share.

The way I understand it, instead of the entire amount consisting of an eligible dividend, it will effectively amount to a sale of 30% of the stock, which means that the cost basis of such shares can be deducted against the proceeds of the sale (for most people, this will be a capital gain). If my understanding of the tax treatment is correct, then the tax burden of such a distribution will be significantly less than the typical special dividend.

However, in the letter to the three top shareholders, the following paragraph is in there:

The Company agrees that it shall designate the full amount of any dividend deemed to arise under the Income Tax Act (Canada) as a result of the acquisition of the Common Shares pursuant to the Arrangement as an “eligible dividend” pursuant to subsection 89(14) of the Income Tax Act (Canada) and the corresponding provisions of any provincial tax legislation pertaining to eligible dividends.

As those three entities own more than 10% of the common stock of the company, such a distribution would be tax-free if given to their CCPC subsidiaries if classified as such. I am not sure whether differential tax treatment is permitting. When the company’s management information circular comes out, reading the tax opinion will be educational as I have never encountered this ‘forced buyback’ in my investing life.

The bite of inflation is hitting commodity companies

All of the resource companies that have reported to date are guiding costs upwards, due to inflation.

For instance, Teck is now guiding unit costs on copper up approximately 6%. Their major capital project at the moment (QB2, a massive copper project which is nearing completion) just ramped up their own costs once again and is signalling that production will not begin until early 2023 instead of 2H-2022 as expected.

Cenovus’ 2022 projected capital costs are going up 10%.

The rest of them will be roughly similar to this – rising costs everywhere.

The impact of inflation will be permeating through the entire economy. Just because companies are going to be making good cash on a high commodity price environment does not make them immune on the cost side.

Commodities are a price-taking industry, the producers more or less sell at whatever the market is willing to give them.

Companies that are price-making (e.g. SaaS like Microsoft) have a lot more power in this environment, but there is an element of elasticity depending on exactly what you’re selling. Those companies that have wide moats will do very well in an inflationary environment.

Real vs. Nominal GDP

When inflation was at 1-2%, the mental adjustment from nominal to real GDP was pretty simple to calculate. If nominal was above 2%, it means you got growth. If it was between 0-2%, you got negative real growth. If it was below 0%, there would be a media panic about the end of the world.

Now with inflation at 8.1%, a nominal growth of 4% might sound good in ‘ordinary times’, but today is deeply negative on the real end. Since almost nobody is getting 8.1%+ wage increases, it means everybody without hard assets are falling behind in relative purchasing power terms.

If we get a 2% real GDP print, with the current CPI rates, it means things increased 10% in nominal terms. Just think of all the extra tax revenues that come out of this (although CPI-linked expenses will also rise, accordingly).

There is also the impact of capital gains taxes to consider. Say you purchased an asset for $100 last year, and today it is $108.10. While you made $8.10 in nominal terms, in real terms, your investment is still worth exactly the same as it was when you purchased it. However, when you go and dump the investment, you owe the government another $1.08 in taxes at Ontario’s highest marginal rate, so you’re actually sitting in the hole. You needed a 11.1% nominal return to ‘break even’! Compounded annually, inflation is a gigantic tax vacuum for the government – and whether you like it or not, we are all paying for it.

The differential in numbers from old times is significant. It will also have the impact of making financial statements from previous eras less comparable.

Effectively, if we string together 5 years of 8% inflation (I’m not saying this will happen, just for illustration), this produces roughly a 50% distortion from real to nominal statistics, comparatively speaking.

Needless to say, this is also very convenient for historical long-duration fixed debt issuers, namely the government. Returns on short-term government debt are still very poor (326bps for 1-year money as I write this, in nominal terms!) in relation to the erosion of purchasing power.

An poker analogy to this is higher inflation means that the casino (government) is taking more rake off the table for each hand. We are all forced to play this economic poker game, but with inflation, the ability to win net amounts of money decreases as the take rises. The big losers are those without assets – their purchasing power continues to erode.