What Do Higher Interest Rates Mean for You?
The Bank of Canada’s about-face could affect your finances in more ways than you think.
The July 12th decision by the Bank of Canada to raise its benchmark overnight rate by a quarter point to 0.75% – its first increase since 2010 – came on the heels of a surprising shift in tone. Gone was commentary fixated on economic worries, replaced by an optimistic outlook on the back of improving data, here, and abroad.
The key question now: will rate hikes be a short-term phenomenon in Canada or are we finally leaving the era of cheap money behind? If you borrow, it’s obvious where interest rates go from here could make a real difference to your finances. But if you save or invest, higher rates can affect you too, perhaps more than you realize.
The economy is showing solid growth
Despite tepid inflation and oil mired in the US$40 to US$50 range, the Bank of Canada is pointing to broadening economic strength, an upswing in employment and a healthier global economy as key reasons why now’s the right time to start raising interest rates.
The Bank is now predicting G7-leading 2.8% real GDP growth for 2017 – Canada’s best annual performance since 20111. Last month, the national jobless rate fell to lows not seen since 2008, echoing confidence from encouraging figures on corporate hiring and investment intentions.2
The bullish about-face from policymakers and talk of higher interest rates have helped reverse the declining fortunes of the Canadian dollar. Our currency hit 80.34 cents US on July 28th, a 10% gain from early May. The loonie isn’t alone. Improving sentiment and economic conditions in the Eurozone and United Kingdom have lifted the Euro to multi-year highs against the US dollar, while the British Pound rebounds from its post-Brexit bottom.
A gradual rise ahead?
By year-end it’s widely believed the central bank will fully restore the 50 basis points in emergency rate cuts made to counter 2015’s oil price shock. That suggests another quarter-point bump would be in the cards. Beyond that the path of future increases is less clear.
The Bank’s upbeat view sees economic recovery driving inflation close to its 2% target in the next year. At the same time, headwinds are threatening to throw a wrench into growth, and in turn, future rate increases, at least in the short-term. One is burgeoning household debt. According to the Parliamentary Budget Office, in the first quarter Canadian households owed $174 for every $100 in disposable income, a ratio expected to climb into next year. Higher interest rates raise debt service costs, leaving individuals with less money to pump back into the economy.
Add an over-levered consumer to the drag on exports from a rising loonie, range-bound oil prices and uncertainty over NAFTA renegotiations, and it’s clear the Bank of Canada is walking a policy tightrope when deciding how aggressive to be with interest rates. Raise too little and there’s a chance inflation will eventually get out of hand. Hike too much and the Bank risks derailing growth.
The delicate balancing act means any path to higher rates is likely to be gradual, giving time for households and industry to adjust. Central 1 Credit Union predicts we’ll see a 1% overnight rate by early September, before climbing another 25 basis points in mid-2018. That translates to a slow rise for bond and money market yields, as well as rates for consumers on products like mortgages and GICs.
What higher rates could mean for you
Whether you’re a homeowner, investor, saver, or borrower, higher interest rates have implications for your financial life.
If you have a mortgage or other debt
How and when interest rate increases will affect you depends on the kind of debt you have.
The good news if you have a fixed rate mortgage is you won’t feel the impact until renewal time. Even then, you might find rates below where they were a few years ago. It could be a different story if you carry other debt. Have a personal line of credit? Expect your interest rate to move with your lender’s prime rate. And, while the size of your payment won’t necessarily change if you have a variable rate mortgage, anticipate more of the amount going to pay interest, adding to the time it takes to wind down the principal.
A small uptick in rates might not concern you. But will that still be true if more hikes follow? Discuss stress-testing your current or planned debt with your advisor and ensure you’re comfortable with higher interest costs. Look for opportunities to save interest by paying down what you owe, so you’ll have less debt to cover if rates do rise further. Reducing debt is like earning a risk-free, guaranteed rate of return that’s often superior to holding cash or conservative investments, especially if you’re in a higher tax bracket.
If you own real estate
The consensus view from housing experts is interest rates would have to increase substantially for real estate prices to be impacted in a major way. That’s particularly the case in Vancouver and Toronto, key markets for foreign buyers and speculators less deterred by rising rates. On the other hand, first-time buyers could suffer a real dent in their purchasing power – or be pushed out of the market altogether – should interest rates continue on an upward path.
The U.S. experience may offer a clue to how our market would fare overall if the Bank of Canada follows in the Federal Reserve’s footsteps of gradual monetary tightening. Rather than falter, the S&P CoreLogic Case-Shiller 20-City Composite Home Price NSA Index, which measures the value of residential real estate in 20 major American metropolitan areas, in May reported a 9.1% gain from December 2015, the time when the Fed began raising its target federal funds rate.
If you hold stocks and bonds
For investors, the consequences of rising interest rates can be a mixed bag.
An inverse relationship between prices and yields means when rates are expected to rise, bond values generally fall. That’s what happened after the Bank of Canada’s suddenly hawkish tone prompted bond investors to push the sell button, hitting prices and sending the five-year Government of Canada benchmark bond yield up more than 70 basis points from early June to the end of July, its steepest climb since late 2016. But, it doesn’t mean the time for owning bonds has passed. They can still make a lot of sense for your portfolio, both for the predictable income they’re able to generate and their diversification benefits.
For stocks, the impact of rising interest rates is less predictable. Higher rates often go hand in hand with a stronger economy. That’s good for corporate profits and equity values. That said, if rates jump too far, too quickly, it can choke off growth prematurely and shift the stock market into reverse.
Equities which rely on their dividends to attract investors – think stocks from higher-yield sectors such as telecom, utilities and pipelines – will likely struggle the most since their payouts lose some of their edge as interest rates rise.
If you own foreign stocks, keep in mind a stronger loonie can lower your returns when measured in Canadian dollars. For example, even though the S&P 500 index in the U.S. hit multiple record highs through June and July, in Canadian dollars the index lost money due to the sharp recovery in our currency.
If you hold cash
Interest rate increases are a positive for cash and cash-equivalents like savings accounts and GICs. One way to capture rising rates is by constructing a GIC ladder, say for three or five years. By staggering your maturities at one-year intervals you’ll be able to reinvest maturing funds for better returns should rates go up. But if they do the opposite, the bulk of your money remains invested at higher yields.
Another option? Choose a flexible deposit like BlueShore’s Jump Rate term deposit which lets you reinvest your funds before maturity.
It’s time for a fresh look
How prepared are you for higher interest rates? Now’s the time to take a fresh look at your finances to ensure you’re properly positioned for the opportunities and risks ahead. Contact your BlueShore Financial advisor for a complimentary review.