When interest rates change, people could see a change in how much they pay for their mortgages, cars and on the return they get on their investments. But any time a central bank changes rates, it does so gradually, and with lots of advance warning, so that people – and markets – have time to adapt.
Rate changes by major central banks like the U.S. Federal Reserve or the Bank of Canada may have wide-ranging implications for the economy, but when faced with a possible rate hike, the question most people ask themselves is, what does this mean for me?
In Canada and the U.S., rates have hovered near zero since the 2008 financial collapse, and that’s led to unprecedented levels of debt. When rates are low and money is cheap, people borrow more than they can afford to pay back. They buy bigger houses, better cars and spend money they don’t really have.
They may think that’s all well and good when rates are low (it isn’t), but when rates rise that exuberance has a way of coming to a halt.
When interest rates go up or down, there’s a corresponding shift in variable mortgage rates – and for those who borrowed near the top of their budget, the shift could be a painful one.
“When people secured their original mortgage, do we really think they calculated what they would be spending if interest rates doubled?,” said Peter McGann, wealth advisor at McGann Wealth Management in Ottawa.
“I think it’d be a very small minority of people that really have a plan B, so what I think that will mean is that any available cash will be used to pay their mortgage, so that’s going to have a huge impact on savings, it’s going to have a huge impact on credit, driving up credit at time when we’re already at record highs in Canada.”
Fixed-rate mortgages wouldn’t see any immediate impact, however, since the rate on these are related to long-term government bond yields.
Credit cards are another area that wouldn’t be impacted by an interest rate shift, because the interest on those is set by companies and based on the risk of people failing to make their payments, not the U.S Federal Reserve’s Fed Funds Rate.
Lines of credit, however, will change with interest rates, because like variable-rate mortgages, interest on lines of credit tends to be tied to banks’ prime interest rate (which is tied to the Bank of Canada’s overnight rate, or the Fed’s Fund Rate). So if you’re borrowing money through a line of credit, your cost to borrow that money will rise if banks hike their prime interest rate, and fall if they lower it.
The impact of a rate change on savers will depend on the financial position they currently find themselves in.
If the person is buried under household debt, or has big mortgage payments that will rise when rates do, he will, in all likelihood, spend all his money trying to pay off those debts and won’t have much left to put into any kid of savings account.
If the person is largely debt-free however, a rate increase could provide some upside.
“There is going to be opportunity for people to reinvest in products that actually will have an above inflation return,” McGann said.
“If we go back to four, five per cent and we’re tracking at a two and a half per cent inflation rate, then maybe vehicles like GICs will become attractive again for senior citizens.”
Rate hikes can be better for some, he added, but typically only for those who have money in the first place and don’t have debt.
For people invested in the markets, it is important to remember that markets tend to be forward-looking, so rate changes tend to be priced in well ahead of time, said Craig Alexander, vice president of economic analysis at the C.D. Howe Institute.
“You then get financial markets quickly trying to price in future rate hikes if they think the central bank is on a path of continuing to change rates,” he said.
Fed rate increases also tend to be a positive sign for markets, because such increases have historically signaled that the economy is recovering, according to John Stephenson, CEO of Stephenson and Co. Capital Management Inc.
And while markets have responded to rate hikes in the past with a selloff on the day of the announcement, “in terms of what direction the market is, in the intervening year or so, after these raises are in, it’s overwhelmingly positive from an historical standpoint.”
For investors in general it’s important to avoid knee-jerk reactions, or feel like they have to completely rejig their portfolio in the event of a rate hike.
“You should be aware of what does move – cyclicals tend to move well and do better than defensive names. Early cyclicals are typically material stocks, they do well in a rising rate environment, financials do well in a rising rate environment, information technology companies do well in a rising rate environment,” Stephenson said.
An Important Reminder
While a rate change will eventually translate into changes to your monthly payments and portfolio, it’s important to remember that rates tend go up gradually.
“To keep this in perspective, we need to recognize that generally speaking, changes in interest rates happen incrementally,” said Alexander.
“When the Federal Reserve changes rates, it will only change them by a quarter of a percentage point at the time.”
That’s meant to ensure people and financial markets have time to adjust to higher rate environments, he added.
“This is also why central banks tend to telegraph what they intend to do well in advance.”