What happens when interest rates rise in Canada?
Interest rates are rising in Canada, and we are already feeling its impact across the board, on the cost of everyday goods and services, and more.
Today’s rising rates have been in the works for a while.
Several years of cheap credit and loose fiscal and monetary policy fuelled consumer demand. Low interest rates encouraged investors to chase yields and invest in riskier assets, driving stock market prices to all-time records.
And the pandemic crisis further increased government spending and caused bottlenecks in the supply chain for many goods. Post-lockdown, we have demand far outstripping supply.
Add on Russia’s atrocious war in Ukraine and the increased cost of oil and other commodities, and you have a mess that could take a while to clean up.
Read on to learn about the effects of higher interest rates on your wallet, inflation, stock prices, mortgages, real estate prices, businesses, and the economy in general.
Interest Rate Increases in 2022
The Bank of Canada has raised its benchmark interest rate thrice in 2022.
First, from a record low of 0.25% to 0.50% on March 2, 2022.
Second, from 0.50% to 1.00% on April 13, 2022.
Lastly, from 1.00% to 1.50% on June 1, 2022, after inflation numbers hit a 31-year high.
For the remainder of the year, the Bank of Canada (BoC) is expected to make interest rate announcements on July 13, September 7, October 26, and December 7, and it is highly likely we will see more rate hikes on some of these dates.
Canadian banks use the BoC’s policy interest rate to set their prime lending rate. As of this writing, the prime rate is at 3.70%.
Effects of High Interest Rates in Canada
Let’s look at how rising interest rates affect:
- Real Estate prices
- Stock market
How Does Raising Interest Rates Affect Inflation?
By raising interest rates, the BoC hopes to reduce inflation.
Higher interest rates result in higher prices for goods and services. This increase in prices ends up slowing demand and encourages consumers to save money.
Raising rates also increases the cost of loan products (personal loans, auto loans, credit cards, mortgages, etc.). When borrowing becomes more expensive, people spend less, and the rate of inflation slows.
Effect of Higher Interest Rates on Mortgages
When the Bank of Canada raises its overnight lending rate, banks hike their prime rate, and variable rate loans become more expensive.
For example, when the BoC hikes its benchmark interest rate from 1% to 1.50%, the big banks increased their prime rate from 3.20% to 3.70%.
If you have a fixed rate mortgage loan, then you have nothing to worry about until you need to renew your mortgage. If you have a variable rate mortgage loan, your debt becomes more expensive.
How does this play out in reality?
For most people with a variable rate mortgage, their monthly payments stay the same; however, a bigger portion of their fixed payment will now go towards paying interest.
If you have an adjustable-rate mortgage (ARM), your monthly payments can change as interest rates increase.
With mortgage rates expected to continue trending up in the short term, it may make sense to convert a variable-rate mortgage to a fixed-rate mortgage (there are many factors to consider).
Also, if your mortgage is coming up for renewal soon, you may want to consider breaking it and locking in for another term at current rates.
What is the Effect of Rising Interest Rates on Real Estates Prices?
Canada’s housing market has been red hot for several years. As interest rates increase, house prices are likely to fall.
As it stands, we have already seen a cooling in the real estate market, with home sales dropping by almost 9% between April and May 2022.
The MLS Home Price Index has also continued to decline since February, with Ontario and British Columbia leading the way.
Higher interest rates translate into:
- Increasing mortgage rates (including fixed rates as bond yields rise). Prospective homebuyers will need to shell out a higher monthly mortgage payment
- New homebuyers may have to pass a mortgage stress test at a higher rate. Currently, the mortgage stress test is at the higher of 5.25%, or the mortgage rate plus 2%.
- A slowdown in demand resulting in home sellers adjusting prices to get a sale.
Canada continues to have a supply problem when it comes to housing. And, at the current immigration levels, the housing market is unlikely to see a sustained and severe correction to the downside.
Relationship Between Interest Rates and Stock Prices
Higher interest rates may lead to lower stock prices. Stock prices often move in tandem with the economy.
Lower interest rates encourage businesses to increase their spending and potentially increase their earnings and profits, resulting in higher stock prices.
Higher interest rates decrease consumer spending, lower business investments, and potentially decrease earnings and profits, resulting in lower stock prices.
The stock markets usually respond to higher interest rates even before its effects kick in.
For example, the expectation of higher rates and an economic slowdown can result in declining stock prices even before this occurs.
Also, when safe investments like GICs and high-interest savings accounts offer higher yields, they become more attractive compared to higher-risk assets like stocks. This may result in funds flowing from the stock market into lower risk investments.
That being said, you could also see the stock market rise during periods of high interest rates, especially in the longer term.
Some market sectors do particularly well in a high-interest environment, such as financial institutions (banks) and energy companies.
Effects of High Interest Rates on Businesses
When the economy slows down (from a combination of factors), many businesses are impacted negatively. Consumers have less disposable income to chase goods and services and demand slows.
Businesses with variable-rate loans spend more money to cover interest costs and they may delay new projects.
Higher rates can also result in the layoff of employees as businesses try to increase their margins.
You may have heard of ‘shrinkflation’ for the first time in the last couple of months. This describes a shrinkage in the size of products while prices stay the same.
Shrinkflation is one of the many tricks manufacturers play when inflation gets out of hand.
Effects of Higher Interest Rates On Your Wallet
To recap, rising interest rates can affect your finances in the long run as follows:
- Your cost of living goes up
- Some loans and mortgage payments will increase
- Stock investment returns may decrease in the short-term
- Interest rates on savings accounts and deposit products will increase (eventually). But, don’t expect to beat inflation rates anytime soon
- Unemployment could worsen as companies lay off workers
- A combination of supply chain issues, high inflation rates, higher interest rates, slower economic growth, and reduced consumer confidence can result in a recession
- The face value (price) of existing bonds drops
How To Play or Profit From Rising Interest Rates in 2022
If the Bank of Canada is successful in its quest, higher interest rates should moderate inflation in the coming months (or year/s).
If you were priced out of the real estate market during the last 2 years, you may get another stab at buying a house at a more reasonable price. Howbeit, with a much higher mortgage rate.
Your fixed-income investments (such as bonds and GICs) will offer better returns going forward.
If you have high-interest debt, this is a good time to focus on paying them off. It may also make sense to accelerate your mortgage payments if you have no other debt.
It has been a while, but mortgage rates topped 20% in the 1980s, and I hope we never see rates even close to that range ever again. But, the short-term trend for mortgage rates is up.
Build a cash cushion in your emergency fund account.
While the stock market appears to be offering up bargains right now, having a solid cash cushion is prudent.
If you have a long investment horizon (i.e. not close to retirement and don’t need funds soon), good stocks are on sale and you could benefit from what could easily become a once-in-a-lifetime opportunity to generate outsized gains.
Consider dollar-cost-averaging (DCA) by setting up regular pre-authorized contributions or purchases to your investment accounts.
If you are already in retirement, you will benefit from higher savings rates, however, falling stock prices are a real concern.
Ideally, a portion of your portfolio should be allocated to cash and cash-equivalent assets (like GICs and T-bills) for times like this so you don’t have to sell stocks and lock in losses.
You will want to manage your withdrawals and spending to limit the impact of this stock market’s correction on your overall portfolio, especially if you have recently retired i.e. sequence of returns risk.
If in doubt about what to do, speak with a licensed financial planner.
Some stocks do well in a high interest rate environment. These include bank and health stocks and consumer staples. That said, keeping your portfolio diversified should remain top of mind.