This article was first published in the Globe and Mail on February 10, 2024. It is being republished with permission.

by Tom Bradley

I’ve been using the phrase “normalization of interest rates” in recent communications with clients because rates are closer to normal today than they were two years ago when homeowners could get a five-year fixed-rate mortgage for less than 2 per cent.

Of course, the risk of using the word “normal” is that readers think I know what normal is. At this juncture, I can’t say I do. It’s open for debate, with a wide range of possibilities. Perhaps I should have said that interest rates are less abnormal than they were two years ago.

I’ll use my personal history to explain the difficulty of declaring what normal is.

When I started in the business in the early 1980s, interest rates were in the high teens. Generations older than me still love to tell stories of buying Canada Savings Bonds that paid 19.5 per cent interest. As it turns out, that was the starting point for a 40-year bull market in bonds. From that point on, yields steadily dropped until they approached zero in 2021. (Reminder: Bond yields are inversely related to bond prices – when yields decline, prices rise.)

It was a remarkable run. Bonds were like my favourite hockey player, Bobby Orr, who was great at everything (if only his career had lasted 40 years). They provided steady income (defence), spectacular total returns (offence) with the help of capital appreciation, and were a great diversifier when stock markets were weak (Orr was at his best at crunch time).

The point of the history lesson (and sports reminiscence) is that it’s impossible to say what “normal” is. Interest rates have been in flux for well more than 40 years. Even if we look at a chart of real interest rates, which are adjusted for inflation, no clear pattern emerges.

What we can say confidently, however, is that near-zero interest rates, which every borrower is hoping to see again, were not normal. Money was almost free for highly-rated borrowers, while lenders (the holders of bonds and GICs) were losing ground to inflation. The money they got back at maturity bought less than the amount invested years before.

In Howard Marks’s latest memo from Oaktree Capital Management, he refers to a quote from the 17th-century that describes interest as “a Reward for forbearing the use of your own Money for a Term of Time agreed upon.” In 2021, it wasn’t sustainable for lenders to be receiving little or no reward for forbearing.

I have a rule of thumb that is far less elegant than Mr. Marks’s phrase – if it’s a great time to be a borrower, it’s a lousy time to be a lender.

If I were to take a stab at what normal interest rates are, a minimum of two conditions need to be met. First, bond yields must be higher than inflation over the term of the security (based on inflation expectations at the time of purchase). In other words, a positive real yield.

And second, for corporate bonds and mortgages, there needs to be a reasonable amount of extra yield compared to government bonds to compensate for the possibility of default. This extra yield is referred to as a spread.

Currently the first box is ticked. Rates are bouncing around but generally running above inflation expectations. The second box is up for debate. The extra yield for taking more risk is small by historical standards. Spreads are on the narrow side.

I’m not here to make a call on interest rates (if I was any good at it, I’d have owned more real estate in the past 20 years). Bond yields have already come down from the highs of last fall and may go lower, but we should be careful what we wish for. A decline to 2021 levels wouldn’t be a return to normal but, rather, a monetary response to a cripplingly weak economy.

And of course, interest rates could even go higher if inflation proves to be stubborn and/or governments need to offer higher yields to entice investors to fund their never-ending deficits.

The point is that I see many people basing their financial and investment decisions on the hope that interest rates will go back down. Hope is not a strategy, especially when it’s for a return to highly abnormal conditions.