If you’ve been following the news recently, then you’re aware that the Bank of Canada has raised interest rates for the first time in seven years. The rate it raised is called the overnight lending rate and they raised it from 0.50% to 0.75%. No sooner did they announce this than the Canadian Big 5 Banks followed suit by raising their prime lending rates from 2.7% to 2.95%. But what does that mean to you?
In the first of our two articles, we looked at the effect of rising interest rates from the perspectives of both borrowers and lenders. Today, we’ll look at how rising interest rates affect the overall economy and what that might mean to your investments.
The economics of interest rates is not a simple topic. Entire university texts have been written on this subject. As a result, it’s difficult to truly do it justice; however, today we’ll try to sum up the relationship that interest rates have with those economic variables that matter most to you.
Interest Rates and Inflation: First of all, why do interest rates need to rise at all?Often times, as was the case after the credit crunch in 2008, governments and central bankers feel that the economy needs a bit of a boost to keep it healthy. By lowering interest rates, it is cheaper to borrow money. When money is cheap to borrow, consumers and businesses take advantage of it, and they use it to do things like buy homes, or invest in their businesses. Unfortunately, low interest rates, particularly long periods of low rates can come at a price. The best example right now is Canada’s overheated Real Estate market. Cheap money (another word for low interest rates), has made buying homes increasingly difficult and costly for average and young Canadians because prices have been driven to astronomically “inflated” levels, particularly in cities like Vancouver and Toronto. To try to cool things down a bit, the Bank of Canada raises interest rates. As the cost of borrowing becomes more expensive, people tighten their belts and pay down debt. This also has the effect of slowing down the economy and potentially lowering or slowing inflation. In the case of Canada, where inflation, as defined by the Consumer Price Index, is still very low, the effort is an attempt to tackle inflation before it arises.
The current concern is that if the Bank of Canada raises interest rates too far too fast, there could be trouble if borrowers can’t afford to pay back their debts and they default on them. As we saw in the United States in 2008, this can be very hard on an economy.
Interest Rates and the Canadian Dollar: Typically, when interest rates rise, so too does the Canadian dollar. This happens because investors from around the world who are looking for safe places to invest their money feel very comfortable with the Canadian government’s ability to pay their debts. As a result, they like a higher interest rate and will send foreign money to Canada to invest. By buying Canadian bonds, they are buying Canadian currency to do so and thus driving up the price of our currency in the process.
Interest Rates and your Equity Investments: This is a tricky one. Generally, if interest rates are rising, it’s a sign of a healthy economy. That in turn, should mean good things for investors in the equity or stock markets.The challenge is that many companies fund their own operations through borrowing. If interest rates are rising, so too are the costs of borrowing and this ultimately affects their profitability. A lower profit could have a negative effect on their stock price and this could ripple across the entire stock market.
Of course with any of these economic discussions, there’s no guarantee that the “rules of thumb” will take place. As mentioned, entire text books have been written on these topics, and the predictability of economic events and their effect on investments has consistently proven elusive to even the most sophisticated of prognosticators.
That’s why at LGK Wealth Management, we don’t spend time trying to predict which direction interest rates are going to go, or how that event will ultimately affect your portfolio once it’s happened. Those events are beyond our control. What we can control; however, is our behaviour, and that is driven by your financial goals and objectives, and your tolerance for volatility and risk. We use asset allocation and diversification to ensure you don’t have all your eggs in one basket. We only hire the best managers that have been rigorously screened before selection. When inevitable portfolio volatility takes place, whether from changes to interest rates or something else, we rebalance your portfolio back to its original asset allocation, thus giving us the opportunity to sell the strategies that are doing well, and buy more of the strategies that are struggling.Ultimately we end up buying low and selling high, which in our view is the essence of successful investing.
In conclusion, what do rising interest rates mean to you? It’s actually fairly straightforward. If you’re household finances are in good shape, then you’re in a position to be a lender and therefore benefit from higher rates. If you’re household finances need some work and you have significant borrowings, now may be the time to focus on getting your house in order. If you’re not sure where you stand, perhaps we can help. Give us a call at (780) 426-2400.