Photo courtesy Chris Wattie of ReutersOn July 12, The Bank of Canada (BOC) raised lending rates for the first time in 7 years; the overnight rate rose 25 basis points to 0.75 per cent. It was a highly anticipated move as futures predicted a greater than 90% chance the hike was coming. Tightening monetary policy has immediate and medium-term effects that touch many aspects of regular life, and we're here to discuss just a few of the impacts it may have on yours.
Foreign Exchange
All things being equal, higher interest rates in Canada would raise the value of the Loonie. This is due to the increased demand from foreign investors purchasing Canadian investments, such as government bonds (debt). Since Canada is a net exporting country, this would reduce the overall demand for Canadian products or make it more expensive for our trading partners to buy our resources. A reduction in demand therefore would reduce economic output. However, it is beneficial for residents that flock to the US for vacations. Needless to say, a higher Canadian dollar increases purchasing power for Canadians travelling aboard, but reduces tourism into Canada. Many argue that a low currency is a more effective economic stimulant than government policy.
Better Bank Profitability
If you are an employed in Canada, then you have a direct interest in the profitability of the financial industry. Other than the fact that banks are one of the largest employers in Canada and we rely on their sustainability as a nation, all working Canadians contribute to some form of pension plan, whether it be privately-held at work or through CPP. Most pension plans invest their funds into mutual funds and in Canada, all mutual funds focused on growth, income, blue chip, or index-matching, possess all five big banks in their portfolio. The reduction in profitability for banks hinders share price and dividend growth.
When interest rates rise, it gives banks larger margins on their lending rates. Banks make money by borrowing short and lending long. Borrowing short means they borrow money from their customers and investors through chequeing accounts and GIC's. The interest rate on these are under 1%. Banks then lend long buy purchasing long term bonds in the market or offering mortgages which are typically 5 years. Rates on 5-year bonds and mortgages have an interest rate about 2.5%. This is the yield curve and is the spread that banks attempt to profit off. This dance exists as long as there is demand for short term investment vehicles and use of chequeing accounts.
Inflation
Most people view inflation as the rise in prices of goods, however, it is not the true definition. Inflation is the reduced value of money and as more money is printed, each unit is fractionally reduced increasing the amount of money needed to buy the same good. Rising interest rates slow down the efficiency of an economy and therefore reduces the demand for money and speed at which money decays. For the average person, this means a decelerating pace of inflation. This may be viewed as positive or negative, depending on your needs. If you have investments, you would seek inflation. This increases the value of the investment. Many however seek slow inflation to combat stagnant wages and increase their personal buying power.
Mortgages
We didn't start off with mortgages as our first topic because it was important to understand how mortgage rates are priced. Some people believe that interest rates on mortgages are aligned with lending rates, however, historically speaking, this is actually untrue. Mortgages move in line with longer-term government bonds. This is often why variable rates move prior to central bank decisions, as was the case last week, when RBC raised variable rates 20 basis points. The longer-term bonds were already moving in anticipation of the Bank of Canada's decision. With that said, although there is no direct impact, mortgage rates should theoretically rise if the Bank of Canada implements one more rate hike in 2017, which is highly expected because longer-term bonds will drop in value.
If inflation declines, then this also leads to a reduction in the long-term bond yields of 10 and 30 year notes. Typically, these long-term debentures are in tandem with inflation expectations. If inflation rates do start to decelerate, then it is highly possible for the value of these bonds to rise and their yields to drop. This could potentially reduce variable mortgage rates without intervention from the central bank.
Consumer Spending
If you're a small business owner, then you should expect to see a reduction in consumer spending. However, the Bank of Canada revised their GDP growth from 2.6% to 2.8% which is an encouraging sign. Historically, the idea of raising rates increases the cost of debt. The average Canadian has over $20,000 of debt, excluding mortgages. Now that rates have risen or may start to rise, more people may start to funnel their cash from expenditures to debt. The direction from money out of the economy into savings and vice versa is the true nature and intent of interest rate decisions and monetary policy.
