The Consequences of Rising Interest Rates

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The Canadian economy is stuck in neutral, but the US economy has been springing back to life after many years of languishing in dormancy. The latest news from the Federal Reserve, the US equivalent of the Bank of Canada, is that the economy is picking up steam and foresees less bond purchases and even hinted at raising interest rates.  A normal person that reads this news probably has no clue about what this might mean for their finances, but there are several impacts on your own person budget that can happen.

If you’re a Canadian, you might not think much about it because you’re thinking that interest rates can never rise here.  There are a lot of misconceptions that people have about interest rates and how they move.  If the US Federal Reserve decides to raise interest rates, it will have a profound effect on Canada.  The Bank of Canada can hold the line on interest rate hikes in Canada, but the fact is, the two economies are still very closely linked.  Considering Canada must compete globally with other countries, changes to other countries’ monetary policy actually has an impact on our daily lives.

So what does happen when interest rates start to rise?  How should we prepare?

  1. Falling Canadian Dollar
    This is already happening right now.  The Canadian economy is growing slower than the US economy.  To reflect that, investor sentiment has shifted to buying US currency over Canadian currency because investors want to put their money where the economy is growing fastest.  The effect of a falling Canadian dollar can be felt with higher prices to import goods.  This in turn means that things that we buy on a daily basis will go up in price.  Oil will also cost us more.  Since oil is traded in US dollars, it means higher prices at the gas pumps.  There isn’t much you can do to mitigate a falling dollar, but if you have investments outside of Canada, a falling dollar can be advantageous because you will get capital gains due to currency fluctuations.
  2. Higher Long Term Mortgage Rates
    Despite what you might think, long term fixed mortgage rates (greater than 5 years) are not set by the Bank of Canada or the Federal Reserve.  They are linked closely to bond prices and the interest rate they yield.  As the US Federal Reserve pares back bond purchases, yields will rise thus causing long term mortgage rates to rise as well.  If you are looking to buy a house, it’s a good idea to lock in long term now.  In the US, 10 and 30 year mortgages are not uncommon.  Why not lock in for the long term to avoid paying higher interest on your mortgage?  Since mortgages are tax deductible in the US, having a long mortgage isn’t even a bad idea.  For Canadians, higher rates are not so great given the fact every 5 years we have to reset our mortgage.  Plan you budget accordingly, and if you’re thinking about buying a house make sure you know how mortgages work.
  3. Higher Interest Payments on Mortgages
    If you are on a variable mortgage, when the Federal Reserve or Bank of Canada decides to raise interest rates, then that will affect short term mortgage interest rates.  This means that if you don’t lock in your mortgage to a fixed rate, more of your monthly payment will go towards paying interest rather than your principal.  It’s a good idea to budget accordingly for the future if you know that you’ll end up paying less of your principal.  When mortgage renewal time comes it might be a prudent idea to save up a lump sum payment to reduce the monthly payments during mortgage renewal.  This means that you’ll need to save for that lump sum payment in your monthly budget.
  4. Falling Bond Prices
    Financial advisers love selling bonds and saying they are the safest investment.  If you buy individual bonds, they will protect a portion of your capital.  Bonds always have a maturity date at which point the original face value is returned to the bond holder.  Before the maturity date; however, bonds trade just like stocks and sometimes a premium exists.  When interest rates rise, bond prices fall, meaning you end up losing money holding bonds.  If you’re holding bond ETFs or mutual funds, then rising rates will decrease the worth of those funds.  Worse yet, ETFs and bond funds don’t guarantee your capital because no maturity date exists for them.  This means that you are not guaranteed your capital when losses start piling up.  Still confused on bonds?  Read my previous blog post on bonds.
  5. Tempered Stock Market
    Rising interest rates means less money supply in the economy.  Less money in the economy means a slower growing economy.  Slower growth means that we have to consider that the stock market will follow that slow growth.  We can’t expect 30% year over year gains in the stock market.  It’s not sustainable.  If interest rates continue to rise, the stock market will be subdued.
  6. Higher Savings Interest
    For the GIC lovers out there, rising rates means that you’ll finally get something out of your GIC investments.  As interest rates rise, so too will the savings interest rates at financial institutions.  Bear in mind, that these rates won’t rise that high.  Banks are still out there to take your savings and lend it out at higher rates.  When you take no risk, the reward will always be low, but at least it won’t be non-existent.

What are the best ways to mitigate rising interest rates in our own investments?  Diversity.  Balance.  Perseverance.  A rising interest rate environment generally requires us to rebalance our portfolios.  Simply buying and holding your investments for life isn’t a strategy that should be used.  Occasionally, it’s necessary to rebalance the ratios of the assets that you hold.  As I have mentioned above, rising interest rates can affect the stock market, bond prices and money markets.  Make sure your own investment portfolio stays true to your goals.

For your own personal budget, make sure you continue to pay yourself first.  You might find yourself with less to spend with higher mortgage payments and more expensive daily necessities, so make sure your own monthly budget stays intact.  Keep a positive cash flow.  If interest rates are rising it can only mean that the economy in the US is growing and that’s a good thing.  Reap the benefits of a growing economy.  Not everything is bad about rising interest rates.

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