The economy and the world are in a precarious situation. Russia invaded Ukraine more than 110 days ago, Inflation continues to rise, and central bankers are saying interest rates will continue to rise.
We have seen supply chain constraints, our cost of living keeps rising, and we will likely experience an increase in both of those going forward. The stock market has also had a rough first half of the year. Many people are finding themselves in situations that they never imagined and do not know how to navigate.
One question that people have been asking with more regularity is “How high will interest rates go?”It is a great question and one that should be thought about and debated. However, the answer to the question is not straightforward.
We want to look at some possibilities and lines of thought on where interest rates could go. We also want to talk about what it means for the average person if interest rates do continue to rise and how you could potentially put yourself in a better position.
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Interest rates are more than just the rate you pay on your mortgage or credit card. An interest rate is an amount a lender charges a borrower and is a percentage of the principal amount. Or said differently, they are the cost of accessing capital. The most important rate is the central bank lending rate. In Canada that is generally referred to as the “Bank Rate” in the states, it is generally referred to as the “Federal Funds Rate”.
When the bank rate increases, other interest rates follow. Whether that is savings rates on GIC and savings accounts, prime rates, mortgage rates, lines of credit, etc. When interest rates rise, it also affects how much credit a borrower would qualify for. This is most easily understood in the context of mortgages. I will talk more about this below.
Interest rates also have an inverse relationship with inflation. This means that when inflation is high like it is now, central banks will raise the bank rate. When the bank rate is higher, credit is more expensive to carry and people/businesses will spend less, hopefully, curbing inflation. The reverse is true, when inflation is low, central banks will lower rates to hopefully, spur the economy forward. So these recent rate hikes are not a surprise.
Interest Rates and Mortgages
So how do these rate hikes affect the average person?
Well, most people have or will have a mortgage at some point. The amount of mortgage you qualify for is based on a percentage of your income. This means monthly mortgage payments (principal + interest) can only be “x%” of your monthly income. Your total mortgage payment is dependent on interest rates. If interest rates go up, your monthly mortgage payment goes up. When monthly mortgage payments go up it takes up a larger portion of your monthly income. In the end, this means that the amount you qualify for goes down.
When this happens it means that the borrower cannot afford to pay as much for a house as they could when interest rates were lower. This means fewer buyers are purchasing real estate and real estate prices should start to drop. This has begun to happen in certain real estate markets already. Buying pressure has begun to wane and prices have begun to drop slightly in Toronto and other over-valued real estate markets.
Unfortunately, someone will be left holding the bag. Those that bought houses at the peak of the market, at the top of their range of affordability, will have a difficult time carrying the cost of their mortgage. They might be okay in the short term if they locked in their rate with a fixed-rate mortgage. However, when it comes time to refinance at the new higher rates, it could be near impossible for them. Those with variable-rate mortgages will feel that pinch immediately as interest rates rise.
This pinch has already been experienced by many Canadians. In a survey by Manulife, 1 in 4 homeowners said they would have to sell their homes if interest rates go any higher. Sadly, those that bought a house and are leveraged to the max, may be forced to sell the house at a loss and will be left holding the bag.
Those that are flush with cash and have been planning ahead may find some great buying opportunities.
Interest Rates and Investing Cycles
As mentioned above, when interest rates rise several things happen: debt carrying costs increase, and business expansion becomes tougher. Those that are leveraged to the max are forced to liquidate assets in order to meet debt obligations. Business expansion will slow or decrease and business valuations will decrease. All this is to say, stocks generally experience headwinds.
However, the strongest effects are felt on bonds. As interest rates rise, the price of bonds falls. The formula to calculate how much the price of a bond falls is more technical than we want to get into here. However, the reason that bond prices fall is due to the reality of new bonds being issued into the market at higher rates. Now someone looking to buy a bond can either buy your current bond or buy a new bond paying a higher rate of interest. To make your bond more appealing to the buyer, you have to offer a discount on what you want for it.
There is a fancy term called duration. Which is essentially the amount the bond price will drop for each percentage point increase in interest rates or vice versa. Essentially, the longer the term to maturity, the more volatility is experienced with changes in interest rates.
How high will central banks raise interest rates? That is the million-dollar question and one that is extremely hard to predict. As we have mentioned in the past, they have found themselves in quite a predicament.
Based on inflation statistics and measures like the Taylor Rule, interest rates are way below where they should be. This is still the case after the most recent rate hikes.
We want to be careful to not fall into a fool’s choice fallacy here, but there are really two distinct possibilities. Either they continue raising rates or they lower rates. Duh! The third option would be for them to hold rates at current levels. If banks continue to raise rates, everything we mentioned above will likely start playing out; the stock market continues to pull back, housing prices start to decline, and bonds continue the downward swing.
There is also the school of thought that says it is too little too late. For interest rates to actually have any barring now, they would have to rise into the low teens. If that were to happen the economy would likely fall into a deep recession. Something economists are now warning about at current interest rates.
However, the alternative may just delay the inevitable. If the central banks want to stave off a recession, they may reverse course, and start lowering rates again. Hoping to ensure the economy doesn’t crash. If this happens, the bubble that has been deflating this year will likely just reinflate without any of the underlying issues being addressed. Issues like government deficits, broken social programs, mass amounts of money printing, consumer debt levels, net worth concentration, housing unaffordability, etc.
Whatever central banks decide to do, something will have to give. Markets and experts are expecting several more rate hikes through 2022 with inflation normalizing in the second half of 2023. We will all be sitting on the edge of our seats to see how it unfolds.
A Note About Inflation
Inflation stats for the US were released last week and they were higher than what was expected. Canadian stats should be coming out next week, and we are aiming to release an update then.
As for what is causing the inflation, it seems clear that it is energy costs. Estimates have been proposed that 80% of the inflation in North America is due to energy costs, and upwards of 90% in the UK.
This makes sense if you look at the way our economy works. Our houses, transportation, etc. all need energy to operate. Everything we have on store shelves is brought there via plane, train, or truck. All of which have had their costs nearly double. Those increases get passed down to the consumer.
If inflation can be almost fully attributed to energy costs, it seems as though the only way we don’t see extremely high inflation and thus interest rates and a recession, is to lower the cost of energy.
It seems as though politicians may be figuring this out as well. President Biden wrote a letter to energy producers in America telling them to boost output or he will invoke emergency measures. Seems strange considering one of his primary campaign promises was to cut back on fossil fuels, ban new drilling, and focus on green energy.
It is our opinion that we will likely see inflation continuing at current levels or being reported higher through the remainder of 2022. This means we will likely see interest rates rise again. How much? That is yet to be determined, it all depends on how the economy responds to current conditions and rate hikes.
Here are our two pieces of advice; Hold strong opinions loosely, and think in possibilities, not probabilities. This means being convicted of your opinions but when circumstances change be willing to change your opinions quickly. This in possibilities rather than probabilities helps to mitigate belief perseverance, and biases, and helps you to think through alternatives more fully.
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Disclaimer: This Forbes Wealth Blog is for informational purposes only and does not constitute financial, legal, or tax advice of any kind. Please consult your legal, accounting, tax, investment, banking, and life insurance professionals to get precise advice relating to your particular situation before acting upon any strategy