Category: Canada

Canadian Interest Rate Futures

At 9am (eastern time) on September 8th, the Bank of Canada will make an announcement regarding the overnight target interest rate, which is currently 0.75%. The 3-month Bankers’ Acceptance futures market currently has the following quotations:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 10 SE 98.895 98.900 98.890 0.000 16669
+ 10 OC 0.000 0.000 98.795 0.020 0
+ 10 NO 0.000 0.000 98.785 0.020 0
+ 10 DE 98.850 98.870 98.850 0.010 19389
+ 11 MR 98.760 98.770 98.750 0.010 12911
+ 11 JN 98.670 98.690 98.650 0.020 6078
+ 11 SE 98.550 98.570 98.530 0.020 3172
+ 11 DE 98.400 98.430 98.400 0.110 363
+ 12 MR 98.270 98.310 98.270 0.100 262

A September and December contract at around 98.85-98.9 is projecting that there is a higher than average chance of a 0.25% rate increase this upcoming meeting, and then no further rate increases for the rest of 2010.

The market is likely going to be correct with this – I anticipate a statement that will state that domestic growth in Canada is quite good, but there remains significant risks outside the country that might affect Canada’s domestic economy.  A 1% short term rate, historically, is still very stimulative.

3-month corporate paper is yielding 0.98% on September 7th and 3-month T-Bills are yielding 0.78%.

In the last decade, the previous low bank rates were 2.25% in early 2002 and in the middle of 2004.

The main impact of the sum of these interest rate increase decisions is that the yield curve will be slightly less steep – traditionally banks make money by borrowing short and lending long.  So when rates were at 0.25%, they could borrow money at that rate, and then lend it out (the ultimate risk-free loan would be to the Government of Canada, which has a 10-year bond yield currently of 2.95%).  You would then skim the difference (2.7%) as profit, which is nearly risk-free.

By increasing interest rates, spreads shrink somewhat.  Assuming the Bank of Canada does raise rates to 1%, the spread will shrink to 1.95% for 10-year money which is still profitable, but not quite as profitable as it was at lower rates.

People with sensitivity to short-term rates (e.g. variable rate mortgages, margin balances in margin accounts) will feel the impact of this increase most directly.

Canadian Interest Rate Projections – August 31

Looking at Banker’s Acceptance Futures, we have the following rates:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 10 SE 98.915 98.930 98.925 0.000 16053
+ 10 OC 0.000 0.000 98.830 0.000 0
+ 10 NO 0.000 0.000 98.820 0.000 0
+ 10 DE 98.890 98.900 98.900 0.000 27314
+ 11 MR 98.820 98.830 98.830 0.000 25451
+ 11 JN 98.740 98.750 98.750 -0.010 8618
+ 11 SE 98.600 98.620 98.610 0.010 1774
+ 11 DE 98.480 98.520 98.490 0.020 1197
+ 12 MR 98.360 98.440 98.370 0.060 386

It looks like that there will be a higher than 50/50 probability that the Bank of Canada will raise their overnight target rate by 0.25% in their September meeting, but after that, future rates in the 2011 calendar year are projected to go up by 0.25% to 0.5%.

The drop in increase expectations has likely contributed to depreciation of the Canadian currency – currently at 94 cents US to a Canadian dollar, while this was high as 98 cents earlier in August, and at parity back in April.  During the depths of the economic crisis, the Canadian dollar reached 78 cents multiple times throughout the October 2008 to March 2009 period.

A basic guide on how to do Canadian equity research

Whenever I hear of a publicly traded company, I follow a fairly standard methodology to do some basic research on the firm.

In a perfect world, you try to do research before looking at the share price of the company. The whole idea of the research methodology is to pin down a valuation for the equity (or in some cases, debt) and seeing a stock price contaminates what should be an unbiased analysis. You want to come up with your own valuation, rather than looking at the market’s valuation and then thinking of ways to rationalize the stock price. Unfortunately 9 times out of 10, the first thing I do is pull up the stock quote. I’ve been trying to train myself to no longer do this, but it is really, really difficult to not see a quote attached to an article.

Once I am ready to research, I pull off these documents from SEDAR in this order:

1. If the “nearest” financial report is an interim statement, I pull down the interim financial statements and MD&A document and read them. Doing analysis on this alone is time-consuming, and you look for tidbits in the statement, get an idea of how the company is capitalized and look at the cash situation. If the “nearest” report is an annual one, I read that and the MD&A.

2. Then I read the management information circular, and look at executive compensation scheme, insider ownership, and executive biographies and get a “feel” for who is running the firm, and who is on the board.

Usually by this point, you can come up with a ballpark number and then it becomes irresistible to look at the share price and hence valuation. Which then leaves:

3. Pulling up the stock chart, and then looking at any significant price moves, and then connecting those price moves to various news releases of the company;

4. Reading every news release of the company over the past X years, chronologically, and then looking at the reaction of the stock to what is significant news;

5. Reading the latest annual report (not the glossy version, the dry financial version) with its MD&A, and/or the Annual Information Form, which is also a good document that has information that is not contained in the interim statements;

6. Insider trading is available on SEDI and can influence a decision. While insider selling is not necessarily a negative signal, whenever you see insider buying it gets your attention much more.

7. The company’s website.

Usually by this point you spent many hours of reading and synthesizing information, and should have a pretty good idea as to what makes the company “tick”. Then the next step is to have a sector-wide comprehension and start investigating competitors, and firms up and down the supply chain to get a feel for the economic variables at stake. This is a never-ending process and eventually at some point you cut it off and then make a buy/sell/leave alone decision.

Learning to prune investment candidates at stage #2 is a very good skill to have – I usually set price triggers on those companies, and when the triggers are hit, I get an email and this triggers me to take a second look at the company to see if anything has changed. In the second half of 2008, so many companies were triggering low price alerts that I had a very, very difficult time keeping up with what was literally an avalanche of securities. I probably could have performed better in 2008 had I had more time to look at all the securities that were flashing at me.

Today, there is hardly anything that triggers my low price alerts, so I am using different screens to put some companies on the research queue.

ING Direct gets into the chequing market

In an interesting corporate strategy shift, ING Direct is now getting into the chequing and bill payment market. The salient details are similar to the local credit union that I deal with, mainly no transaction charges and a nominal fee for other basic services (ordering cheques, writing bank drafts, etc.).

ING Direct used to start off as a basic business model where you can save your money at a high rate of return – ING Direct would then use this as collateral to write mortgages, and then make the money off the spread between the mortgage rates and the savings interest paid. As their deposit base grew, they eventually morphed from giving their clients the best rates available to just giving slightly above average rates for savings. They are now out-competed by Ally and other providers.

As there is nothing preventing competition for funds, the only barrier for customers to switch banks is simply to fill in an application form. Since the interest spread between ING Direct and Ally is 0.5% on short-term savings at present, it is a $50 difference on a $10,000 deposit for a year. While this is not a gigantic amount of money, it is likely worth it for those that can spend the 20 minutes applying and getting an account.

As for the chequing account, I was assuming that the funds you leave on deposit would be earning ING Direct’s typical interest rate on savings, but it is not – apparently the first $50,000 will earn 0.25%, and the remainder will be earning more. This is far below the 1.5% that ING Direct offers.

So what is the point of opening an account? Typically the convenience of opening such a chequing account would be that it works completely in synergy with your main ING Direct account, and offering the high rate while you keep your cash idle in the account. Instead, you still have to go through the same procedure to transfer over your money from the high rate account to the lower rate chequing account, and then make the cheque or bill payment.

I don’t think this is going to attract the type of clients that ING Direct wants, mainly those that keep large amounts of deposits in the account.

It is also interesting how most banks probably take a loss processing these accounts – the big money maker on the retail end are for mortgages, loans and credit card interest debt.

Bank of Canada Interest Rate Projections

Since the last 0.25% rate increase on July 20, the bankers’ acceptance futures have been quite calm. We have the following quotations:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 10 AU 0.000 0.000 98.905 -0.005 0
+ 10 SE 98.825 98.835 98.825 0.000 1825
+ 10 OC 0.000 0.000 98.725 -0.005 0
+ 10 DE 98.700 98.710 98.700 0.010 6190
+ 11 MR 98.580 98.590 98.580 0.010 4636
+ 11 JN 98.460 98.470 98.460 0.010 2213
+ 11 SE 98.310 98.320 98.310 0.000 904
+ 11 DE 98.140 98.150 98.130 0.010 303
+ 12 MR 97.950 97.960 97.940 0.020 104
+ 12 JN 97.770 97.790 97.760 0.020 54

This still hints that the short term rate will rise 0.25% by the September 8 or October 20 meeting, and the short term rate will end the year at 1.00% with a possibility of 1.25%. For the year 2011, rates are expected to inch higher by about 0.5 to 0.75%.

It should also be noted that at present, 3-month corporate paper is yielding 0.89%. This was approximately 0.4% half a year ago.

Finally, since 5-year bond rates have dropped considerably over the same time period (which is counter-intuitive to the economics 101 texts that state that longer-term bond yields will rise with an increase in interest rates), 5-year fixed term mortgages should also drop – the best one I can see so far is 3.87%.