As expected, the Federal Reserve raised its key lending rate, the federal funds rate, on March 16th, two weeks after the Bank of Canada raised its rates. Canadians wondered, “how will this affect me and my family?”
Families pay interest on outstanding debt, and receive interest, dividends, and capital gains on their investments. This means that each person’s and family’s unique situation will be affected differently, in accordance with their unique debt and investment situation. For borrowers, the cost of capital will be rising, and for lenders, their income will be increasing. If you have more invested assets than you have in outstanding debt, consider yourself to be a ‘net lender’.
As a net-lender, the interest rate hike is good news. If you are a net-borrower, some of the bad news will be immediate, but most of the effects are likely to be delayed. The most complicated implication will be the reaction by equity markets. As with most economic and financial changes, there will be winners and losers.
What you need to know
Depending on the investment vehicle, the effects of an interest rate increase can be delayed or immediate. If you have investments or loans that have a floating rate or are exposed to market fluctuations (credit cards, line of credit), interest charges will rise.
If you have a GIC or a mortgage with a fixed term, rates will stay in effect until maturity or renewal. Variable rate mortgages, Home Equity Lines of Credit (HELOC) and high interest savings accounts will see the Federal Reserve and Bank of Canada’s new rates implemented almost immediately, and Canadians will start to receive or pay higher interest.
The effect of increased interest rates on the stock market is not as uniform. For example, financial firms, such as banks and insurance companies, are typically more profitable when interest rates are higher. Firms that borrow in the short-term to finance production will face higher costs that could lower profits sooner than companies with locked-in long-term commitments, like utilities and their bonds.
The bottom line
If an investor’s portfolio is dominated by a small number of large stock holdings, they might experience some short-term volatility and risk, since profitability drives share price, all other things being equal.
However, most investors have both fixed income investments (GICs) and variable investments (stocks, ETFs, Mutual Funds). In addition to different asset classes investors also place their funds domestically and internationally, and across multiple industry sectors to accommodate their risk/reward tolerances.
Central banks, like the Federal Reserve and Bank of Canada, do not act rashly and this small interest rate rise was expected and predicted. Portfolios are built to the unique needs of each investor and to withstand these types of changes with diversification.