The Wealthy You #2 - How the Bank of Canada Interest Rate Hike Affects Your Money

Earlier this morning, Bank of Canada Governor Stephen Poloz announced that the Bank would be increasing its target overnight rate for the first time since 2010. The move increases the Bank's policy rate from 0.5% to 0.75%, a rate that is still extremely low by historical standards. This article will look at the way increasing rates (in any country) could potentially affect various asset classes and impact your investments.

Some Context

The latest rate cuts came in 2015 when the Bank lowered rates by half a percentage point to 0.5% following the drop in oil prices, one of Canada's key exports. The move aimed to kickstart the economy by lowering the value of the Canadian dollar to help boost exports, while also stimulating consumption through cheaper borrowing.

The latter has started backfiring, with the key real estate markets of Toronto and Vancouver building substantial bubbles and the average Canadian household debt reaching historical highs. In light of these developments, and now that the Canadian economy is growing above its potential growth rate, many economists and policy analysts saw a need to start increasing rates.

Canada is the first G7 country outside of the United States to start hiking rates, but with more and more talk around the tightening of monetary policy, there is reason to believe that other countries might start following the United States' lead as well. This could obviously have a significant effect on yields around the world, which in turn would affect the value of various asset classes. Let's now take a look at some of those:

Real Estate

Real estate prices are usually inversely related to interest rates. This happens for two reasons; when people refinance their mortgage (typically once every 5 years in Canada) at a higher rate, they might not be able to afford their new payments, which will force them to sell. This in turn increases supply, and an increase in supply without an offsetting increase in demand will push prices down. We know that demand won't be increasing to offset supply at the original prices, because when rates increase lenders will grant lower mortgage limits compared to when rates were lower.

What this means for you is that if you are planning to buy real estate as an investment in an expensive market compared to historical norms and household income (Greater Toronto and Greater Vancouver areas are the main culprits in Canada), this might not be the time to do it. Instead, it might be better to keep saving your money to be able to snap up some nice properties once prices eventually take a hit. If you already own a place or plan to purchase real estate for the long run, this might not affect you as much.

Stocks

Stocks also typically decrease in value when interest rates increase and the yield curve moves up. That is because the rates used to discount future cash flows are higher. Investors will also require a higher return on stocks through the risk premium when interest rates are higher; that is, they will want higher potential returns on stocks to take on their risk if they can now receive higher risk-free rates through higher government bond yields, leading to lower stock prices.

Some stocks will be affected differently than others when it comes to rising interest rates. Bank stocks, for example, stand to benefit from increasing rates as their Net Interest Income increases from lending at higher rates while barely paying more on deposits. On the flip side, severe increases in interest rates could lead to more borrower defaults, which would hurt banks - but that doesn't pose much of a risk in the short term. Insurance companies also generally benefit from higher rates, as they are able to achieve higher returns with the premiums paid to them. At the other end of the spectrum, REITs are one of the sectors that definitely stand to lose (see Real Estate above). Other losers are companies whose revenue relies strongly on exports, however that is less clear as these companies will only hurt if higher rates lead to a stronger national currency.

What a potential yield increase means for you and your stock investments depends on many factors, the most important of which is whether or not you will need to access your funds in the short term.

If you are a young investor planning for retirement and you plan on having your money in the stock market for another 25 years, then there really isn't anything required of you. You could - if you like to manage your assets actively - sell some of your positions while the market is doing great and buy them back once the market pulls back later on; however, there is no guarantee that this will happen and you might miss out on further gains.

If, however, you are an investor close to retirement, you might want to carefully consider how a pullback in stock prices would affect your future. Increasing yields have the potential to create economic busts which lead to devastating declines in stock prices, as we witnessed almost a decade ago.

Bonds

When interest rates rise and the yield curve moves up, the value of existing bonds will decrease – that is, interest rates and bond prices are inversely related. The reason for this is that when yields move higher, newly issued bonds will pay higher rates than existing bonds; existing bonds thus become less attractive, and must trade at lower prices in order to offer the same yield as newly issued bonds.

The implication for you as an investor depends on your style of investing. If you are planning on holding bonds until they mature, then you are not really affected by price fluctuations and you could roll over your bonds for ones with higher yields as they mature. No biggie. If, however, you like to buy and sell bonds to capture capital gains you will want to be more careful, since as yields keep increasing the value of existing bonds will keep decreasing. If you really want to trade the bond market, a better strategy might be to use financial instruments to bonds.

In Conclusion

The rate increases we are seeing at the moment in Canada and the U.S. are fairly negligible and are unlikely to have much of an effect on assets such as stocks and real estate yet. Faster and prolonged increases, however, would definitely impact those asset classes. Finally, the above is for informational purposes only and does not constitute investment advice. You should definitely conduct your own research or consult with your financial planner before taking any decisions.

I hope this post helped you understand the implications of increasing interest rates a little bit more! Please feel free to comment if you think I missed anything, if you would like to share how you are preparing to face rising rates, or simply if you found the article useful. Upvotes are always welcome as well =) Thanks for reading!

Enjoy today,

William