The impact of interest rates on the markets

Louis-Frédéric Bélanger

The impact of interest rates on the markets

In recent months, rising interest rates and inflation have been a source of concern for financial markets and the economy. In February 2022, Statistics Canada announced that inflation was still very high with a 12-month variation of 5.7% (Statistics Canada, 2022), which is much higher than the inflation control target of 2% set by the Bank of Canada (the Bank). This target was chosen to meet the Bank’s monetary policy of preserving the value of money by keeping inflation low, stable, and predictable, allowing Canadians to make spending and investment decisions with greater confidence, thereby promoting long-term investment in the Canadian economy and contributing to sustained job creation and productivity growth (Bank of Canada, 2021).

In order to maintain inflation between 1% and 3%, the Bank adjusts the target for the overnight rate (policy interest rate) on eight pre-set dates per year. The policy rate is the interest rate at which financial institutions lend funds to each other in the financial markets for one day. Banks and other financial institutions use this rate to set the interest rate on personal loans, mortgages, and all other forms of lending. The logic is that if inflation rises above the target rate, the Bank could raise the policy rate. Financial institutions would then have an incentive to raise the interest rate on personal loans and mortgages, thereby discouraging borrowing and spending, and easing inflationary pressures. On the other hand, if inflation is below target or if the country’s economy is not doing well, the Bank could lower the policy rate to encourage financial institutions to reduce the interest rate on personal loans and mortgages, thereby stimulating economic activity so as not to fall into a phase of persistent deflation.

In 2020, in response to the Covid-19 pandemic, the Bank lowered the policy rate to its floor value of 0.25% to support the economy. On March 2, 2022, the Bank of Canada increased the policy rate by 0.25% to 0.50% (Bank of Canada, 2022) to relieve inflationary pressures. This was the first increase since October 2018, but it will not be the only one if inflation is to be brought back to its 2% control target. Indeed, some analysts expect to see four more increases by the end of 2022, which would bring the policy rate to 1.50%, its pre-pandemic level.

Interest rates and the housing market

As mentioned earlier, interest rates on mortgages (and other types of loans) are positively correlated to the policy rate. The variation of these rates influences the pace of the real estate market.

On the one hand, for homeowners, it is those with variable mortgages rate that will be most affected by the recent increase in the policy interest rate. Indeed, most of the time, in the case of a mortgage with a variable rate, the monthly payment is fixed. However, when the interest rate increases, the portion of that payment that is used to pay down the principal amount borrowed decreases, and the portion that is used to pay interests increases.

On the other hand, low-income individuals and first-time homebuyers will also be affected by rising interest rates as it increases the value of the mortgage. Ratehub.ca illustrates it well: for a variable mortgage rate rising from 0.90% to 1.15% following the Bank of Canada’s decision, a mortgage of $436,116 (median price of a house in Canada) amortized over 25 years with a monthly payment of $1,624 will now cost $1,673, $49 more per month or $588 per year. In total, it will be $14,700 more that a person will have to pay off his mortgage for a small 0.25% increase in the interest rate. As a result, the salary and credit history required to get approved for a mortgage will be higher.

In short, economists predict that this increase could weigh on housing demand, but that the impact will not be felt until the second half of the year or until 2023. In fact, it usually takes six to 18 months for a policy rate increase to have a real effect on the economy (Ballard, J., Ferradini, B, 2022).

Interest rates and stock markets

“Interest rates are to asset prices what gravity is to the apple” (Warren Buffett, 2013). This famous phrase that Warren Buffett repeated several times throughout his career illustrates the relationship between interest rates and asset values.

Essentially, when interest rates fall, asset values rise and when interest rates rise, asset values fall. This is because when a central bank raises the policy rate, banks raise their rates for consumer loans. In theory, this means that there is less money available for consumer spending. Similarly, higher rates on business loans, and thus higher debt costs, can sometimes cause companies to slow down their expansion and hiring. The reduction in consumer and business spending can then lead to a decline in the value of a company’s stock (US Bank, 2022).

In addition, when the policy rate increases, the risk-free rate, which is often associated with the 10-year Treasury bond yields, also increases. Since an investor can have a higher risk-free return, he or she will demand a higher return on his or her stocks, which are naturally riskier. Conversely, when the policy rate decreases, the value of assets tends to increase and the returns demanded by investors is lower, which generally pushes up the prices of stocks.

Also, there does not seem to be a clear correlation between the performance of a particular sector or industry and the change in interest rates, but in general, the financial sector performs well with a rise in rates since financial institutions can lend money at a higher rate. On the contrary, companies that are highly leveraged will tend to perform worse than their cost of debt will be very high, thus reducing their profits. Companies that are not profitable will also tend to perform worse in a high interest rate environment, since the present value of their future cash flows is worth less. Investors will therefore not be willing to pay as much for such companies.

Finally, in the stock market, nothing concrete needs to happen for the stock market to react to interest rate changes. In other words, the mere fact that the central bank announces a rate hike can cause businesses and consumers to reduce their spending. If this happens, we could see a drop in profits and a drop in stock prices even before the policy rate increase is realized. This is one of the reasons why the stock market is often referred to as a market of anticipation.

Interest Rates and Bonds

Interest rates and bonds have an inverse relationship: when interest rates rise, bond prices fall, and vice versa. Newly issued bonds will have higher coupons after rates rise, which reduces the value of low-coupon bonds previously issued in a lower rate environment.

It is important to understand the following two concepts regarding the relationship between bonds and interest rates:

Paper yields and Paper Losses: If a bond is purchased at $1,000, or par value, and the Bank increases the interest rate, this could reduce the market value of the bond to $900 (hypothetical situation). In this case, the paper loss would be $100, but this loss is only on paper, unless the bond is sold at that time. If the bond is held to maturity, 100% of its original par value should be distributed to the holder (in addition to the coupons), unless the issuer defaults (US Bank, 2022).
Fluctuation in interest rates and market rates: When interest rates fluctuate, the market rate of a bond will also fluctuate. However, not all bonds are affected in the same way: bonds with shorter maturities are generally less affected by interest rate fluctuations, while bonds with longer maturities will generally suffer a greater loss on paper (US Bank, 2022).

In short, short-term interest rate changes should not affect the long-term outlook for an investor with a long-time horizon and an appropriate mix of stocks and bonds (balanced portfolio). Indeed, declines in bond prices will likely be offset by increases in bond prices at some future date.

Conclusion

To conclude, interest rates drive everything in the economic universe. It is therefore important to evaluate the sensitivity of one’s investments and assets to interest rate fluctuations. Diversification (both in different asset classes and geographically) can, for example, help preserve the value of an investment portfolio against the effects of changing interest rates. Also, having a long-term investment horizon greatly reduces interest rate risk. In short, in the current context, it will be interesting to observe if future policy rate increases will reduce inflationary pressures and how the economy and the markets will react to these possible increases.