How higher U.S. interest rates may affect you
Based on the smoke signals rising from south of the border, the U.S. Federal Reserve Board is poised to raise its key interest rate by a quarter-point when it meets on June 14-15.
Your initial reaction may be: So what? The actions of the U.S. central bank have little to do with us.
Actually, they do. Even with the Bank of Canada continuing to stand pat, a rate increase by the Fed would affect our savings, investing and spending decisions in numerous ways, good and bad.
Here are some examples:
Agrowing U.S. economy
The really good news is that a Fed hike indicates the U.S. economic recovery is healthy and has momentum. No central bank is going to raise rates if the economy appears to be at risk of backsliding. A strong American economy is essential to our own national livelihood, since the U.S. is by far our No. 1 trading partner.
A weaker loonie
Even though interest rates in Canada are higher than in the U.S., our currency has been losing ground to the greenback. Another hike by the Fed (the last one was in December) would put more downward pressure on the loonie.
In fact, that process has already begun. Our dollar has slipped from close to 80 cents (U.S.) earlier this month to its current level. Since oil prices have been firm, increased expectation of a U.S. rate increase is the obvious culprit.
A weaker loonie is good news if you’re an exporter or a film producer. It’s bad news for southbound travellers and in the supermarkets. The higher U.S. rates move — and there is talk of at least one more hike this year — the deeper into the tank the loonie will go and the more your purchasing power will erode.
Falling bond prices
When interest rates rise, bond prices fall. It’s one of the axioms of investing. When the Fed raises its target rate, the yields on new lowrisk Treasury issues will move higher. That makes older issues with lower coupons less attractive, driving down their prices.
Bad news for U.S. stocks
The U.S. stock market tends to react badly to rising interest rates, for three reasons. First, higher rates add to the costs of heavily indebted companies, such as utilities, by increasing their interest expense. Second, rising rates boost the greenback against foreign currencies, cutting into the profit margins of multinational companies. Third, as yields rise, low-risk bonds become more attractive compared to higher risk stocks. The net result is to take some of the steam out of Wall Street.
Mixed signals for Canadian stocks
The Canadian market won’t necessarily react in the same way as New York, since it is more resource based. A stronger greenback aids energy producers and miners whose output is priced in U.S. currency — think oil, gold, potash, etc. The greater the disparity between the loonie and the greenback, the more they benefit from a combination of higher revenue and lower costs. However, interest sensitive securities such as real-estate investment trusts (REITs) and utilities will likely feel negative spillover effects from higher U.S. rates.
Higher bank profits
We’ve been in a low-interest rate environment for so long, many people have forgotten what it’s like to see rates steadily moving higher. But the banks haven’t forgotten and they’re just itching to see the Fed act. That’s because low rates are bad for business and a strain on the bottom line.
Here’s why: When rates are at rock bottom, as they have been, the spread — the difference between the percentage banks pay depositors and what they charge on their loans — is very low. As rates increase, the banks have more manoeuvring room to increase spreads, and therefore profits. So it should come as no surprise that bank indexes in both the U.S. and Canada have rallied strongly in recent weeks after hitting a two-year low in February.
Clearly, there are winners and losers in a rising rate scenario. Knowing which is which may earn you some profits down the road. Gordon Pape is editor and publisher of the Internet Wealth Builder and Income Investor newsletters. His website is BuildingWealth.ca