Low interest rate environment: A thing of the past?
Canadians face a significant financial adjustment this year. Low interest rates have rebounded and are currently at their highest since 2001. It underscores the importance of reassessing your investment strategy to ensure long-term financial health.
Interest rates plunged from 2% to 0.5% in early 2020 as the Bank of Canada (BoC) did its best to stimulate the economy.
Then in March 2022, inflation began to bite. The consumer price index rose above 6%, far exceeding the 2% rate that the BoC considers ideal. In response, the BoC began raising the interest rate again to stop the economy from overheating.
Initial modest quarter-per-cent rises during this period soon gave way to two half-per-cent rises in early 2022. Then, the BoC issued a full percentage point rise—the largest in over 20 years—in July 2022.
The rate increased by another 2% since then, bringing it to 4.75% as of June 2023. Recently, the BoC increased the rate by 25 basis points (bps) bringing it to 5% as of July 12, 2023. All eyes will be on the BoC and the Fed today as they make their respective interest rate announcements.
What does this all mean for how you manage your money? Let's take a closer look.
What higher interest rates mean
By curtailing inflation, rising interest rates can cool down increases in the cost of living. They slow the cost of everything from gasoline to groceries.
However, the further that interest rates rise, the more dangerous things become for the economy. Rising rates increase the cost of borrowing, making it more difficult for businesses to grow. They can also make existing debt more expensive by spiking interest payments. That's worrying for the 71% of Canadian small businesses that took on debt to cope with the impact of the pandemic.
Higher interest rates can drive up the value of the Canadian dollar by attracting foreign investment capital. That gives vacationing snowbirds more bang for their buck abroad. It also makes it less expensive for Canadian businesses to source materials overseas. On the downside, it's a problem for companies that export because it makes their products less attractive to overseas customers.
Housing and investment implications of high interest rates
Rate hikes also make borrowing more expensive for consumers. Those with loans tied to the prime rate face higher interest costs.
One of the most significant implications of high interest rates is seen in housing. A fixed-rate mortgage will lock in the interest rate at the time it was created for a set period, but those with variable-rate mortgages face higher interest rates in the short term.
They can carry significant effects. A monthly payment on a 25-year $300,000 mortgage would have been $1,270 at 2% interest. That leaps to $1,744.81 at 5%.
On the flip side, high interest rates can be good for savers. Those with fixed income investments such as bonds or GICs enjoy higher returns and increased purchasing power.
Investing in a time of high interest rates
Debt becomes more expensive when interest rates are high, so consolidating and paying it down should be a priority.
It's also important to consider the impact on your investments. High interest rates make fast growth difficult, so consider buying stocks with solid fundamentals rather than promises of stellar growth.
Pay extra attention to dividend-paying stocks that return solid short-term cash flow. For the same reason, bonds can be a good bet in a high interest market, but consider shorter-term bonds, which tend to maintain their value better in high-interest environments.
More rises on the horizon?
The Bank of Canada's cooling measures have had an effect. As of June 2023, the consumer price index was back to 4.4%. The bank hopes to see it fall to 3% this summer but has acknowledged that a full return to normality will take time. The markets—along with consumers—will be watching closely to see how much further it falls and how quickly.
While we wait, let's be grateful we haven't yet seen a return to the bad old days of the early 1980s when the interest rate reached a staggering 21%. Today's rates are still modest by comparison.
If you'd like to discuss the current interest rate environment or if you have questions about your investment portfolio, please reach out to me anytime.