Learn why interest rates rise and fall, and what it means for your portfolio investments.
CIBC Investor’s EdgeJun. 17, 2021
Interest rates are often called the cost of money. Actually, they are the price you pay, or someone pays you, to borrow and lend money for a specified period of time.
For example, when you buy a guaranteed investment certificate (GIC), the financial institution is borrowing your money and paying you for its use. It then lends your money to others and makes a profit by charging them more than it is paying you.
Why do interest rates change so often?
You’ve likely noticed that institutions in the money-lending business frequently change their posted prices.
So, why do interest rates bounce around?
The most important reason is inflation. When inflation is high or expected to be high, lenders know that they will eventually be paid back with dollars that are worth much less than the ones they loaned. So, they insist on a higher interest rate to compensate for the loss of their money's purchasing power.
However, interest rates move up or down even if inflation expectations remain constant. That's because when the economy is humming along, businesses can find more opportunities to profitably use the money they borrow from you, and are willing to pay more for it.
Where does the Bank of Canada fit in?
The Bank of Canada sets national monetary policy and supervises banking operations throughout the country, making it a pretty powerful force.
When the Bank of Canada is worried that the economy is expanding so fast that more inflation may result, it tries to cool things down by pushing up short-term interest rates high enough so that businesses and individuals won't want to borrow so much money.
In contrast, when the economy is contracting, the Bank of Canada pushes rates down to stimulate borrowing and spending in hopes of boosting the entire economy.
How do interest rates affect my investments?
Changes in interest rates can significantly affect different types of investments. Some stock prices may decline as companies pay more for loans and raw materials when interest rates increase, causing lower profits.
Interest rate changes also have a predictable impact on at least one money-loaning vehicle: bonds. Rising interest rates drive bond prices down, and falling rates drive them up.
What’s the reason for this? Well, the day a bondholder decides to sell his or her bond, current market rates determine the price. The bondholder sells for less when interest rates are higher than the bond's rate, and for more when interest rates are lower. Usually, the more years the bond is from maturity — the date of repayment, the bigger the price change.
So, why does it matter? Well, you can reduce your risks when making investment decisions by paying attention to the Bank of Canada announcements on falling or rising interest rates.