Bank of Canada Rate Increase

The much anticipated announcement from the Bank of Canada (BoC) has come and gone, and the result was as many were expecting – the BoC has raised Interest Rates. Now, most people will think that only affects their mortgages, but there's a trickle-down effect to several portions of the Economy and Market as a whole. 

Let’s take a look at why the BoC decided to raise rates and the overall effects. First, the ‘why’.

Controlling inflation seemed to be the main speaking point in regards to the reason for the interest rate increase. The BoC feels that the overall Canadian Economy is performing well and to prevent it from overheating and inflation getting out of control, a rise in interest rates would help keep the numbers where they want them. They feel the housing market has started to stabilized, exports are strong due to the weaker Canadian dollar, they have seen oil prices have rise and, from what the BoC says, business investment is growing. All these reasons have caused, what they say, the economy to grow, and therefore justified the rate increase.

The Impact: 

• Household Debt – This is the obvious one. As interest rates rise, the cost of borrowing rises with it. This mostly impacts Mortgages and Line of Credits, which are products that the majority of Canadians have. So, as rates go up, the amount of money used to pay those debts and the amount of interest that those debts cost increases as well. The biggest impact is on any debt that’s linked to prime such as variable rate mortgages and Line of Credits. However, those who are renewing their mortgages (whether into a fixed or variable) will of course be impacted as well since now it will generally be more expensive to service their mortgage than before. Close to 50% of mortgages in Canada will renew in 2018, which is astonishing, and lenders will be having some nice margins on their products!
• Household Spending – Higher interest rates generally leads to lower consumer spending for the average person. This is generally because there are less dollars in the pocket to spend and people are not as willing to get more into debt as they were before, since the cost to service that debt is now higher. What this also does is delay major purchases such as homes and cars, and in turn, slows down the economy.
• Real Estate Market – Anything that impacts mortgages or interest rates inevitably impacts the Real Estate Market. As mortgage rates rise, it becomes more difficult for people to qualify for mortgages, or qualify for the amount of mortgage that they want. This impacts what they can afford to purchase for their home, and also impacts the prices which sellers are able to sell for. We can expect to see home prices be impacted by any change in rates, generally having prices move down as rates move up. The market has already come down a big chunk since its peak from a year ago, however, we can expect to see a further slowdown going forward. Don’t be surprised to see another 15-20% drop in Real Estate prices when everything is said and done!
• Stock Market – A rise in interest rates also affects segments of the stock market. The main portion being affected is the bond market, where bonds move in the opposite direction of rates. Therefore, if rates go up, bond prices go down. In English, that means lower returns for bond or fixed income portfolios. And since most investment portfolios have a good amount of allocation into fixed income/bonds, the increase in rates will have some negative impact on most people’s portfolios, making it important to understand what the impact might be and adjust accordingly.
• Corporate Borrowing - Another affect that isn’t spoken about much is the borrowing of money by banks and corporations. Over the last several years, major banks and corporations have been borrowing cheap money and buying back their own stocks, which has created artificial demand in the market and in turn has inflated the stock prices (i.e creating fake growth). This has resulted in the markets looking a lot better than they actually are. As rates rise and companies borrow less, this growth slows down, and in turn, will create negative consequences for the market, likely resulting in some pullback in stock prices.
• Business Growth & Job Creation – Small and medium size businesses also borrow money for running operations, expansion, research & development, equipment etc…, and when rates go up, it’s more expensive for them to do so. As rates increase, banks generally also tighten lending guidelines making it more difficult for small and medium businesses to borrow money, which hindrances their ability to grow. This also means that companies become less profitable and as they are not spending as much on growing their companies, which in turn slows down job creation.

As you can see, rising interest rates can, and generally do, have a significant impact on multiple aspects economy, not just on the mortgage and debt side. Also, even though the BoC is trying to convince us that everything is going well and on track to meet their targets, they are actually creating more volatility and uncertainty in the market. The decisions they make are likely to push the economy into a recession sooner rather than later.

Interest rates are still at near historical lows, but they will continue to rise over the short, medium and long term - and that the affects can be drastic. This means the cost to service debt will continue to increase, markets will continue to be volatile, housing prices will continue to suffer and the overall economy will likely see some tough times ahead.

Next Steps

Knowing that rates will continue to rise and that the overall economy is still fairly shaky, we need to make sure that we are in a situation that is prepared going forward. Although the BoC is trying to convince us that they can control inflation and keep rate increases at a slow and gradual level, we can’t be certain of their ability to do that. As long-term averages for interest rates are 6-7%, we don’t know how long it will take us to get back there, and if the BoC raises rates too much and too fast, it will push the market into a deep recession and put a lot of people in very difficult situations.

The next steps would be to evaluate your own current situation and to see if there are any changes that need to be made. Since a mortgage is the largest debt and obligation that the majority of Canadians will have, it would be recommended to start by reviewing your mortgage situation. As mentioned above, close to 50% of mortgages in Canada will renew/mature this year, and that is a great opportunity to position yourself so that you are prepared and protected for what’s to come down the road. Even if your mortgage doesn’t renew this year, it still makes sense to look at all your options and potentially even break the existing mortgage to save on interest and headache in the long term.

Next would be to take a look at your overall plan and specifically Investment Portfolio to see how these changes may impact your portfolio going forward. As the Economy nears a tipping point, it's very critical to be in a strategy that will protect you on the downside, WHEN (not if) the markets make a big drop.

Get in touch with me and I can go through all the options with you. You can be certain that by dealing with an Elite level Financial Advisor, all aspects of your Financial Plan will be prepared for any changes in the market, whether positive or negative.