Derek, how do rising interest rates impact my investments?
Rising interest rates often have a negative effect on investment portfolios. The Bank of Canada increased overnight rates twice in the past three months, which does more than just change what money can be borrowed for. The change is likely to be noted by investors as their portfolios adapt to the new rates.
The Gross Domestic Product (GDP) of a country measures the overall health of the economy. Generally speaking, the higher the GDP, the faster the economy is growing. If GDP figures show that the economy is growing quicker than expected, the Bank of Canada can take the measure of increasing rates to moderate and regulate inflation. Simply put, higher rates discourage people and businesses from borrowing money, while lower rates encourage borrowing and thus spending. Too much spending can hike the price on goods leading to higher inflation.
Figures from late spring showed that Canada’s GDP was stronger than expected which prompted an interest rate increase by the Bank of Canada, moving the rate from 0.5% to 0.75% in early July. The most recent GDP figures released at the end of August showed growth again at a faster rate which prompted another increase from 0.75% to 1.00%.
With an understanding of why interest rates increased, we can now assess how this change affects investment portfolios.
Rising interest rates tend to have a negative effect on fixed income investments such as bonds. The reality of the changes may be complex, but we can simplify the concept. If you invested in a bond with a fixed interest rate for the next 10 years, an increase in interest rates makes your bond less attractive to investors. What then happens is that the price you can sell your bond for today decreases. This is a very basic explanation as there are numerous other factors to consider.
While it also true that an increase in interest rates helps future bond rates, it does impact existing bonds prices in the immediate term. With this information in hand, bond investors likely saw a decrease in their portfolios over the past three months.
Rising interest rates also tends to move the currency of a country higher. Since early May, the Canadian dollar has increased over 13% to where it stands today around $0.82. While travellers heading to the US may be excited by the gains, investors generally have little to cheer about.
Generally speaking, any investment that is made outside of Canada takes on the risk that goes with changing currencies. The example is that if the Canadian dollar has increased by 13% since May, your US-based stock would have had to increase also by 13% just to break even. Since investment statements typically are reflected back to Canadian dollars, it’s likely that most investors have noticed that their portfolios have declined, or haven’t grown at the same pace as foreign markets.
Lastly Canadian investors have witnessed the Toronto Stock Exchange (TSX) move progressively lower in 2017, as foreign investors maintain concerns about the housing market in Canada and the pressures of persistently low oil and gas. Despite what our GDP figures show, the economy and the stock markets are rarely in sync. Year to date the TSX is down nearly 3%. So while not necessarily linked to interest rates, Canadian investors are finding little gains in bonds, foreign equities, and even Canadian equities.
The Bank of Canada will likely continue increasing interest rates as GDP figures support further growth. While these changes are out of an investor’s control, it may be worth having a discussion with a local Wealth Advisor to ensure your portfolio is properly balanced and diversified for the changes ahead.
Senior Wealth Advisor – Scotia Wealth Management