What fast-rising interest, inflation and bond rates mean for investors

How much did the Bank of Canada raise interest rates?

On April 13, 2022, the BoC raised the country’s benchmark interest rate by half a percentage point. This was the country’s first interest rate hike to exceed 25 basis points in more than 20 years. Tiff Macklem, the BoC governor, has already stated the rate may go up another 50 basis points in June. The Federal Reserve increased its interest rate by 50 basis points on May 4, 2022.

Why? Central banks, including the BoC and the Fed, are under pressure to fight inflation, and raising interest rates is the go-to tactic to get soaring prices under control. In April, Canada’s inflation rate reached 6.8%—a 31-year high. In the U.S., inflation hit 8.3%—a slight drop from March.

If left unchecked, high inflation will make it harder for businesses and individuals to meet their debt obligations. The cost of carrying debt (the interest paid) has already increased significantly, especially for lines of credit tied to the prime lending rate and for variable-rate mortgages.

With that as a backdrop, let’s dive deeper into the most-asked questions I’m getting from investors and why I’m still optimistic.

Why are the markets so volatile?
The markets don’t like change they’re unable to plan for. If the BoC’s Macklem and the Fed’s chair Jerome Powell had indicated 50-basis-point increases were on the horizon when they first announced the raising of rates multiple times in 2022, then we wouldn’t be seeing so much volatility today. Instead, the markets would have factored that information into pricing.

Are we heading into a recession?
Underlying this question is the fear that the central banks are raising rates too high and too quickly, which will slow economic growth, which is already happening. By raising interest rates, the central banks are trying to get businesses and consumers to think twice before spending, which in turn will curb inflation.
In many ways, the central banks are walking a tightrope. If the interest rate increases are too low, they’ll make little to no impact on spending and inflation. If they’re too high, the economy could slow to a standstill, possibly resulting in a recession.
I’m not worried about a recession at this point. The true definition of a recession is two consecutive quarters of negative economic growth, as measured by gross domestic product (GDP). We saw a similar situation play out in the fourth quarter of 2018, when both the BoC and the Fed raised interest rates at a time when the economy was slowing. Then, as now, there were market sell-offs because people took their eyes off the long game and focused on rising interest rates, inflation and costs. Today, however, unemployment rates are at all-time lows. Answer this: How do you have a recession when everyone is working and contributing more to the economy?

Which industries are hardest hit by the current market volatility?
Technology stocks, in particular, are taking a beating, but the reasons aren’t clear. Major players such as Microsoft, Apple and Google are enjoying strong earnings and top-line growth. But bank stocks are falling because of rising fears of a possible recession. Too-high interest rates could lead to fewer people taking out mortgages and some people defaulting on mortgages and loans. I think fewer mortgages and more defaults will lead to a negative impact on housing down the road. For example, if the BoC raises interest rates by 1.5% in the span of six months, then some households could see their mortgage rates double. What happens when people can no longer afford their mortgage payments?

Is this the peak of inflation?
It’s hard to say because of the impact of the Russia-Ukraine war, which has caused oil and natural gas prices to surge, further increasing inflationary pressures. I’m hopeful that inflation will stabilize and give the central banks reason to pause interest rate increases. If that happens, I anticipate we’ll see a rally in the markets.

Why is the 10-year government bond rate increasing so fast?
Investors, investment professionals, experts and the financial media have been focussing on the rates for 10-year government bonds over the past several months, particularly the U.S. 10-year government bond. In mid-December 2021, as it became increasingly clear that the BoC and the Fed would be increasing interest rates in 2022, the U.S. 10-year government bond rate started rising. Market volatility also seemed to increase as the bond rates rose in the U.S. and Canada.
The 10-year bond rates accelerated in March, April and May 2022, as inflation rates continued upward and speculation grew that the central banks’ initial rate hikes this year would likely be greater than 25 basis points, as they sought to combat inflation. Both banks ended up making 50-basis-point increases in 2022, so far.
The markets aren’t in favour of higher rates, so when the 10-year U.S government bond briefly climbed above 3% in the first half of May 2022, markets sold off.
The 10-year government bond rates are key benchmarks that often influence the interest rates of other products, such as mortgage rates and lines of credit. If the 10-year rate goes up, chances are that the interest rates on mortgages and lines of credit will also increase, and we’ve started to see this happen.

Should investors invest now?
Consider this a buying opportunity. If you look back over the past 25 years, you’ll see the markets have rebounded from the 1999 tech burst, the 2008 financial collapse, the 2011 Greece debt default, the end-of-year sell-off of 2018 and, of course, the COVID-based collapse of 2020. This time should not be any different.

Every time these things happen, people have the same fears. Just remember, the market takes the elevator on the way down and the stairs on the way up. Stay invested and, if you can, take advantage of the current environment. Buy quality companies with pricing power and good top-line growth that are now on sale.

That’s what I’m doing.

Allan Small is the senior investment advisor at the Allan Small Financial Group with iA Private Wealth (allansmall.com) and he is the author of How To Profit When Investors Are Scared. He can be reached at [email protected].