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The Impact of Rising Interest Rates


On December 14, the U.S. Federal Reserve Board (the Fed) raised its benchmark interest rate by 0.25%. The move reflects the Fed’s intention to return borrowing costs to more “normal” levels and stem future inflation, as the U.S. economy and job market continue to grow.
 
A growing U.S. economy is generally good for Canada, as the U.S. is our largest trading partner. With interest rates rising in the U.S., in time the Bank of Canada will increase rates here. To help you plan for the prospect of rising rates, here’s a breakdown of the overall effect on certain investments.

1. Higher returns on cash -- People with money market investments or savings accounts are poised to benefit from rising rates, as they will be able to generate more return on their cash.

2. Cost of borrowing will increase -- Higher interest rates mean consumers will have to deal with higher borrowing costs. Those holding loans tied to short-term or floating-rate debt will be immediately impacted. Conversely, homeowners holding fixed-rate mortgages with lower locked-in rates won’t be negatively affected, compared to those with variable rate mortgages.

3. Some bond prices will fall -- Bond prices typically fall when interest rates rise. Why? The interest paid by a typical bond always stays the same, so only changes in the bond price would result in different levels of yield. Bond prices move in the opposite direction of interest rates. Consider this example: All else being equal, you wouldn’t pay the same price for a bond that provides a 2% yield as one that provides a 3% yield. However, if the price of the first bond was lower so the yield was also 3%, then it would be more in line with current interest rate levels. It’s important to remember that holding a bond to maturity will mean your principal value won’t decrease. 

4. Longer-term bonds directly impacted -- In a low-rate environment, many investors may have locked in higher yields with longer-dated bond holdings. However, longer-term bonds are more sensitive to interest rate changes than short-term bonds, so their values may decrease more when rates rise. 

5. Good news for certain stocks -- If borrowing costs increase, businesses with lower levels of debt and more cash may perform better than similar companies with higher levels of debt. In addition, financial firms that lend money to clients will profit from higher interest revenue. Historically, the real estate, energy, consumer discretionary and technology sectors have usually benefited in a rising rate environment.

6. Mixed news for some sectors -- Higher interest rates mean higher borrowing costs, which affects firms that sell capital-intensive goods like heavy machinery and automobiles. Hard assets, such as gold, may under perform when U.S. rates rise, as investors choose the safety of the strengthening U.S. dollar.

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