The Bank of Canada raised its key interest rate again on Wednesday, saying that the global economy is looking good and that the new U.S.-Mexico-Canada Agreement has made trade less uncertain (USMCA).
The key rate is now 1.75 percent, up from the last rate of 1.50 percent. This is the fifth rate increase since last summer.
Officially, the rate is called the target for the overnight rate or the policy interest rate. It determines the interest rate banks charge each other when they borrow and lend money overnight. It’s closely watched because it’s a good sign of where other interest rates, like mortgage and consumer loan rates, are going.
When the Canada Bank raises its overnight target rate, it wants to slow down borrowing and spending to keep inflation in check.
What does it mean for investors when interest rates go up? Here are some things to think about:
Fixed Income (FI)
Bonds, bank bills, guaranteed investment certificates (GICs), and mortgage-backed securities are investments that pay out a fixed amount each month. Here, we’ll look at bonds to show what might happen if interest rates go up.
Bond yields may rise as markets expect a rate hike.
Changes in interest rates can be hard for bonds because the price of bonds tends to go down when interest rates go up. Interest rate risk is one of the few things that bonds are sensitive to. Other things are inflation risk and credit risk. Interest rate risk is the risk that interest rates will go up, causing the market value of a bond to go down. What is going on? The bond price may go down if its coupon rate is lower than that of similar bonds that were issued more recently at higher rates. Even though the bond’s price is going down, its yield is going up, which keeps it competitive in the market.
Even though the price of existing bonds may go down when interest rates go up, interest income could be put to better use if invested at a higher rate. There may also be bonds on the market with higher yields or new bonds with more attractive coupons.
Keep In Mind
If you maintain a bond until it matures, changes in its market price will less affect you. Interest payments are predictable over the bond’s life, and the principal is likely to be paid out at maturity as long as the issuer doesn’t default.
Even though fixed-income returns may be low in the short term, many still think that a strategic allocation to fixed income is a key part of a well-diversified portfolio.
Stocks
The traditional way of thinking is that higher interest rates are bad for stocks. This perspective is based on a few things:
- Companies may have to pay more to borrow money if rates go up, hurting their return on capital.
- When rates go up, investors may be more interested in safe, interest-paying instruments like bonds, which could decrease the demand for stocks.
- If rates go up, companies may have to spend more to pay off debt and less on capital investments, which could slow the growth of their future earnings.
It’s important to keep in mind why interest rates are going up. When the Bank of Canada started to act again in 2017, it partly did so because of a strong economy, which included a strong job market. A strong economy can help businesses make more money.
Margin Counts
Do you have a financial asset? The interest rates on margin loans have gone up, which is in line with the recent rise in the cost of borrowing. You have to pay more for these resources if you want to use your investments as collateral to get a loan.
You Should Know About Interest Rates and Foreign Exchange
Interest rates and foreign currency rates are inextricably linked.
Currencies tend to move along with interest rates, even when people talk about interest rates going up or down. When interest rates go up, currencies tend to get stronger when there are signs that currencies will go up. The justification for this is that higher interest rates can make investors from other countries interested in a currency. This can improve the demand for a currency and, in turn, may make the value of that currency go up.
When you hear or read that the Canadian dollar got stronger before or after a rate hike, the U.S. dollar is usually used as a comparison. Since the U.S. is the biggest economy globally and Canada’s biggest trading partner, the greenback is often used as a standard for the loonie.
High currencies might influence domestic returns.
If everything else stays the same, a stronger loonie usually lowers the returns on investments in countries whose currencies have gone down against the Canadian dollar. Even if the price of investment hasn’t changed, if the loonie is stronger now than when you bought it, you’d be getting less “bang for your buck” if you converted the foreign prices back to Canadian dollars. Currency exchange costs don’t matter if your U.S. dollar investment is held on the U.S. side of your account. Don’t forget that you can change your U.S. dollars into Canadian dollars whenever it works best for you.
No magic wand.
It’s hard to know when a currency will go up or down, so it’s best to be careful when making investment decisions based on what you think will happen to a currency.
Most accounts contain dollars.
You can hold U.S. dollars in accounts like Tax-Free Savings Accounts (TFSAs), Registered Retirement Savings Plans (RRSPs), Registered Retirement Income Funds (RRIFs), and many others. A Registered Education Savings Plan is one exception to this rule (RESP). U.S. securities can be held in RESPs if the money is in Canadian dollars. All accounts, except RESPs, automatically let you hold U.S. dollars in them.
Real-time exchange rates
Clients of RBC Direct Investing can now get real-time exchange rates and convert Canadian and U.S. dollars to other currencies in real-time during foreign-exchange hours. On business days in Canada and the U.S., that means about 7:45 a.m. to 4:45 p.m. If a foreign exchange transaction request is made outside of these times, it is handled the next business day.
