What Should Investors Do, At the Start of an Interest Rate Cut Cycle?

The Bank of Canada lowered its interest rate twice by 0.5% in October and December, bringing the total rate cuts in 2024 to 1.75%. These successive rate cuts are set to gradually impact people’s investments and daily lives. What potential changes might affect us during this rate-cutting cycle? And how should we adapt as the cycle progresses?

?

1. The End of Lazy Investing

An investment return rate of 4% has traditionally been seen as a dividing line. When it’s easy to achieve returns above 4%, people often opt for “lazy” investment strategies. For example, with GICs (Guaranteed Investment Certificates) offering an annual interest rate of 5%, many people would forego more complex, riskier, and potentially higher-return investments, choosing instead to park their cash in GICs.

?

However, as we enter a rate-cutting cycle, it will become increasingly difficult to find GICs with high returns once existing certificates mature. This means that lazy investing strategies will become unsustainable in this environment.

?

The trend towards GICs began in the latter half of 2022 when interest rates were consistently rising. If one had instead invested in an S&P 500 index fund during that time, their returns today would be around 40%. This demonstrates the significant opportunity cost of “lazy” GIC investments.

?

When people’s GICs mature, they may come to realise the potential losses they’ve incurred over the past two years. Investments that don’t require effort or strategic thinking tend to deliver returns that align with this lack of engagement.

?

In a rate-cutting cycle, returns on money market funds will also decline significantly. This, coupled with declining GIC rates, is likely to release large amounts of cash from these two “safe havens.” That cash will start seeking opportunities in the capital markets, real estate, or be used to repay debt.

?

The safest use for cash is to pay down consumer loans. It’s recommended to accelerate the repayment of mortgages on primary residences, regardless of whether the interest rate is high or low. For debt that generates income, such as investment property loans, accelerated repayment isn’t necessary.

?

Investing in the capital markets—whether stocks or bonds—carries higher risks at present. Over the past two years, stock prices have risen consistently without significant corrections. While bond prices are expected to rise gradually, benefitting those who already hold bonds, the room for further price appreciation is limited for those entering the market now.

?

In short, cash is becoming a “hot potato” rather than a safe haven. The easy returns from passive strategies will be a thing of the past as rate cuts take effect.

?

02 Interest Rate Cuts and Asset Prices

?

Assets are defined as properties or investments that generate income for investors. Therefore, a primary residence isn’t considered an asset in an investment sense. Instead, investment properties, stocks, and bonds—assets that produce income streams—fall into this category.

?

Investment returns consist of two main components: future income streams and wealth appreciation driven by asset valuation. The present value of an asset is determined by discounting its future income streams, and the lower the discount rate, the higher the present value of the asset.

?

An interest rate cut lowers the risk-free rate and, consequently, the discount rate. This means that even if future cash flows remain unchanged, the present value of assets increases. The Discounted Cash Flow (DCF) method is the most widely used model for valuing assets.

?

When interest rates are reduced, the valuations of real estate, stocks, and bonds tend to rise. This creates an advantageous position for investors looking to cash out and lock in their gains. However, for those who are not currently invested, deciding whether to enter the market becomes a complex question.

?

Bonds and Interest Rate Cuts

When interest rates are lowered, the yields on newly issued bonds decline, making previously issued bonds with higher yields more valuable. This is because bond prices and yields move inversely.

?

With continued interest rate cuts, bond prices will likely keep rising. Over the past two years, many investors anticipated rate cuts and rushed into the bond market to capitalize, only to face disappointment as those expectations weren’t fully realized. As a result, many investors remain stuck in bonds, waiting for prices to recover.

?

Given the significant amount of trapped capital waiting to break even, the recovery of bond prices during this rate-cutting cycle is expected to be a gradual process.

?

For fixed-rate mortgages, lower bond yields bring good news. As interest rates decline, fixed-rate mortgage products are likely to follow, easing the financial burden on borrowers. This will gradually alleviate concerns about the “mortgage renewal cliff” as borrowers renewing their loans in the future will benefit from lower rates.

?

Stocks and Interest Rate Sensitivity

Stock valuations are highly sensitive to interest rates, largely due to their reliance on the DCF model for company valuation. The DCF model uses two key factors: a company’s projected future cash flows and the discount rate.

?

The discount rate is often derived from the central bank’s risk-free rate. If a company’s future cash flows remain constant, a higher discount rate reduces its present value, while a lower discount rate increases it. As such, rate cuts by the Bank of Canada can boost overall stock market valuations.

?

While lower interest rates are generally positive for the stock market, the degree of benefit varies across sectors. Historically, small-cap and cyclical stocks tend to have greater potential during rate-cutting cycles.

?

Small-Cap Stocks: These companies often rely more heavily on short-term debt, and rate cuts significantly reduce their borrowing costs, lightening their financial burdens.

Cyclical Stocks: Sectors like technology, consumer discretionary, real estate, and finance are typically more sensitive to interest rate changes. Lower rates can improve profitability and boost valuations in these industries.

Gold and Interest Rates

Gold does not generate income, meaning it offers no yield. As a result, during rate-hiking cycles, gold prices tend to be suppressed. Conversely, in a rate-cutting environment, gold prices are often supported.

?

If the U.S. Federal Reserve begins cutting rates, the decline in risk-free rates could lead to an outflow of U.S. dollars, weakening the U.S. dollar index. Since gold is priced in U.S. dollars, a weaker dollar can drive up gold prices.

?

However, gold’s primary role remains that of a safe-haven asset. Its value increases during times of geopolitical or economic uncertainty. While interest rate cuts are a factor that may push gold prices higher, the actual price level is influenced more heavily by global stability, making it difficult to predict.

?

Real Estate and Rate Cuts

The beginning of a rate-cutting cycle often marks the final opportunity to purchase properties at relatively low prices.

?

When rents rise and borrowing costs decrease, property owners become less inclined to sell. Sellers who initially planned to cash out may reconsider and withdraw their listings, breaking the stalemate that often characterizes market uncertainty.

?

The valuation principles for real estate are similar to those for stocks, as both rely on the DCF model. A property’s value equals its future rental income divided by the discount rate. As rate cuts lower the discount rate, the denominator shrinks, and property prices rise.

?

?

?

03 Can Interest Rate Cuts Continue?

?

When discussing the Bank of Canada’s policy stance, terms like "dovish" and "hawkish" are often used to describe its inclination towards cutting or raising interest rates. A dovish stance prioritizes controlling unemployment and favours rate cuts, while a hawkish stance focuses on maintaining stable purchasing power and advocates for rate hikes.

?

When unemployment rises, it’s the doves’ time to shine. Looking at Canada’s current employment situation, it’s clear that the hawks have completed their mission and flown away.

?

Canada’s Unemployment Story

Canada’s unemployment rate is a long-standing and multifaceted issue, tied not only to immigration policy but also to labour productivity. Reliance on cheap foreign labour and reduced corporate investment have exacerbated unemployment. On top of that, the Bank of Canada’s overly aggressive rate hikes last year—twice exceeding prudent levels—have pushed the current unemployment rate above the Bank’s target.

?

The Bank of Canada is generally expected to raise rates when inflation exceeds 2% and cut rates when unemployment surpasses 6%. However, it has faltered on both fronts.

?

Currently, Canada’s unemployment rate sits at 6.8%, well above the 6% threshold. Whether ongoing rate cuts can successfully rein in this unemployment remains an open question.

?

In my view, the Bank of Canada should continue cutting rates until unemployment returns to around 6%. Therefore, it’s likely that rate cuts will persist for some time.

?

The Outlook for Rate Cuts

Major commercial banks predict that the Bank of Canada will continue its rate-cutting cycle. By the fourth quarter of 2025, it’s anticipated that the policy rate will reach a neutral level of 2.75%-3%.

?

04 How to Act?

The last time interest rates dropped was during the pandemic in late March 2020, when rates hit rock bottom. Back then, public reaction to rate cuts was as slow as it is now. It wasn’t until July 2020 that early adopters began purchasing properties, pushing Greater Toronto Area (GTA) housing prices up by 46% in just 18 months.

?

After rates started climbing in March 2022, property prices declined for nine consecutive months before stabilizing at year-end. The GTA housing market saw an approximate 18% decline, but prices have held steady since then. From an average of $880,000 in late 2020, GTA home prices peaked at $1.28 million in February 2022, dropped to $1.05 million, and are now steady at $1.1 million.

?

Families who seized the opportunity during the rate cuts ultimately saw a substantial increase in home equity. Meanwhile, those who opted for "lazy" investing, like moving funds into high-interest term deposits during the rising rate period in late 2022, missed out on other opportunities. For example, the S&P 500 index has surged 40% since late 2022. This underscores a key lesson: in times of rate changes, doing nothing or making reactive decisions can lead to missed opportunities and significant opportunity costs.

?

The cost of inaction or complacency is a combination of economic shifts and one’s ability—or inability—to adapt. During the industrial era, income gaps were narrower, economic cycles were less frequent, and most people could afford to remain static without significant financial repercussions. However, in today’s information age, income disparities have widened, economic fluctuations are more frequent, and the costs of complacency are far higher than they were 30 years ago.

?

Steps to Take

Classify Your Savings:

Separate your family’s savings into long-term funds for investments and short-term funds for emergencies.

?

Invest in What You Understand:

Choose assets you are familiar with. If you don’t fully understand the underlying investments, it’s often better to avoid them. Real estate is a transparent and tangible asset, while other options like equities may require more learning and experience.

?

Maintain Cash Flow Balance:

Ensure your investments do not compromise your quality of life.

?

During periods of high interest rates, people tend to focus more on short-term cash flow and immediate consumption costs, often overlooking the benefits of long-term investments. Irving Fisher famously defined interest rates as a measure of people’s impatience—the higher the rate, the less willing people are to delay gratification and think about the future.

?

Over the past two years, concerns about cash flow have left most people locked into survival mode, unable to focus on long-term goals. This is human nature, and only a small percentage can rise above these constraints. Rate cuts, however, provide financial and mental breathing room, gradually encouraging people to shift their focus to long-term planning.

?

Investment Opportunities During Rate Cuts

Establish Long-Term Portfolios:

Allocate resources towards long-term investments like real estate and index funds during the easing cycle. Real Estate Investment Trusts (REITs), for example, are likely to see their valuations rise as interest rates drop.

?

Real Estate and Stocks:

Lower rates will increase valuations for equity and ownership-based assets. While gains may be modest until quantitative tightening ends, patience is key. Both property and stocks can generate rental or dividend income, making them attractive even if the initial purchase price is high.

?

If rent prices continue rising, property values will eventually recover due to improved yield, attracting more investors. Early adopters can benefit from these trends.

Advanced vs. Basic Challenges:

Enduring “advanced challenges” for half a lifetime is better than struggling with “basic challenges” for a full lifetime—or even two.

?

Learning from Examples

During the pandemic, many longstanding family-run restaurants closed down despite two generations of hard work. These businesses often operated on slim profit margins, and their owners worked tirelessly for decades only to see their efforts wiped out.

?

This is an example of enduring basic challenges—working hard without creating sustainable, passive income. Contrast this with McDonald’s business model, as portrayed in the movie The Founder. McDonald’s isn’t just about selling burgers; its true success lies in using its cash flow to fund real estate investments.

?

The Final Lesson

To achieve financial freedom in the latter half of life, one must master investing. While hard work generates active income, it is passive income that sustains long-term wealth. Advanced challenges—like learning, maintaining leverage, and navigating compounding returns—require effort, vision, decisiveness, and resilience. However, enduring these challenges for a shorter period is far better than working endlessly with no financial safety net.

?

In short, investment is everyone’s final career, and those who master it can make their wealth work for them, rather than working for their wealth. Start early, act decisively, and build for the long term.

?

?

Conclusion

?

The U.S. presidential election has captured the world’s attention, and this year it’s particularly dramatic. Even the vice-presidential candidates, who are typically seen as secondary players, are stealing the spotlight. One is from the 1960s generation, the other from the 1980s; one owns no primary residence, while the other has a net worth nearing $10 million.

?

The way each person views the world is shaped by the altitude of their own financial foundation. This isn’t just an American phenomenon—it’s increasingly true in Canada as well. The polarization of politics has reached alarming levels in both countries, and rather than bridging divides, the trend appears to be growing. The root cause? Widening wealth inequality.

?

For those not in politics but living ordinary lives, the question becomes: would you prefer to live like Waltz or Vance? In today’s information age, being indifferent to change or clinging to an unchanging lifestyle amounts to falling behind.

?

I don’t have a long list of specific recommendations to offer, but one thing is clear: responding to change is key to a fulfilling life. If you want to learn how to invest, start by investing. Learning by doing.