Interest rate changes and your investments

Financial markets fluctuate for a combination of reasons, but few factors are as influential as when central banks set policy interest rates. Understanding the “why” gives you greater insight into how financial markets work and, more importantly, how the outcome can affect investment performance.

What are interest rates?

An interest rate is essentially the cost of borrowing money. Typically, it’s a percentage of the amount borrowed on an annual basis. For example, if you borrow $1,000 dollars and the interest rate is 10% annually, you owe $100 at the end of the year. The interest rates you pay on your credit card debt or your mortgage depend on various economic factors. Ultimately, though, they stem from central bank policy decisions. The Bank of Canada adjusts the target for its key rate on eight fixed dates each year.

Why do central banks adjust interest rates?

Central banks around the world set their respective monetary policy to manage currency and money supply. By controlling the cost of borrowing money, they can better support stable economic growth.

The Bank of Canada, for example, says its objective is to promote the economic and financial well-being of Canadians.

Policy-makers have determined that the best way to do this is by keeping inflation – the rate of change in the price we pay for goods and services – from rising too quickly. This is measured by the percentage change in the consumer price index.

The Bank of Canada sets its inflation-control target collaboratively with the federal government every five years. The current target is 2% (expires December 31, 2026) within a control range of 1% to 3%. Adjusting the overnight lending rate - often called the policy rate - is the primary tool policy-makers use to exert control. This number sets the rate that central banks use for lending to commercial banks, which guides the prime rate that banks then use to set rates for their customers for credit cards, lines of credit and mortgages.

What happens when central banks change the policy rate

Central banks raise interest rates when they want to slow the pace of rising prices. This increases the cost of borrowing, which slows business and household spending, and helps mitigate inflation over time.

Conversely, when economic growth is slow and employment is down, central banks will lower the policy rate to support business and consumer spending and spark economic activity.

How do rate changes impact your investments

This depends on the type of investments you hold. At a high level, here’s how rate changes have impacted common investments in the past.

Equities

Holding more high-equity investments can be beneficial when central banks cut rates because it makes borrowing money less expensive for those companies. Lower borrowing costs results in higher company earnings, which can be reinvested for growth or passed on to shareholders in the form of dividends. At the same time, investing in fixed income becomes less attractive when interest rates drop, so investors shift more money toward equities, driving up share prices.

Fixed income

Bonds tend to have an inverse relationship to interest rates: their price rises when interest rates go down, raising the bond’s potential return to the holder (if the bond is not held to maturity). This means investment funds holding bonds benefit because new bonds are issued at lower rates, making the existing bonds with higher rates more attractive, driving up the price.

GICs

Lower rates make the yield on GIC purchases or renewals less attractive. If you purchase a five-year GIC when interest rates are falling, your investment will be lower than a five-year GIC issued when rates were high.

Historical perspective: Market performance and interest rates

Returns: Compound annual return for >1 year; holding-period return of less than 1 year

Sources: Morningstar Direct, Bank of Canada

Returns: Compound annual return for >1 year; holding-period return of less than 1 year

Sources: Morningstar Direct, Federal Reserve Economic Data

Key take-away: Manage the impact of interest-rate changes with a diversified portfolio

Investing in quality, professionally managed and diversified investment funds is helpful regardless of the current policy rate. With a diverse portfolio, you have access to several different asset classes, geographies and investment styles, which lessens your risk if one segment of the market underperforms others. Portfolio managers have the expertise to adjust allocations as market conditions change. A Co-operators financial representative is always ready to help if you have questions or would like to review your plan.