Interest rate hike no cause for concern

In probably the least surprising move of the year, the Bank of Canada announced Tuesday that it is raising interest rates by 25 basis points to 4.5%. The move comes as a result of a stronger than expected economy and a soaring Canadian dollar.

“The Bank judges that the economy is now operating further above its production potential than was projected [in April],” said the Bank in a release. “Both total CPI and core inflation have been higher than projected in April and are above the 2% inflation target.”

Minutes after the announcement, the big banks raised their prime lending rates by 25 bps to 6.25%.

With all the anticipation around the rate hike — the first since May 2006 — some clients might begin to panic. But Duncan Stewart, portfolio manager at Stewart Financial in Oakville, Ont., says a 25 bp increase isn’t cause for too much concern.

“From a long-term perspective, it’s probably not all that important,” he says. “Asset allocation, spending patterns, budgeting — it shouldn’t affect any long-term strategic planning.”

Where the rate hike will have some effect is with leverage. “A lot of people out there are highly levered, both on the asset side and debt side. We could see a crunch coming with a lot of Canadians.”

He also emphasizes that it’s imperative for a client to have a balanced portfolio to mitigate risk, especially if interest rates continue to rise.

“There’s likely going to be a recession in the next three to seven years, and we all know what that does to a portfolio,” he says. “With a balanced portfolio, a 25 basis point increase in interest rates shouldn’t affect you that much. It’s when you get away from that balanced mentality that you get big problems.”

Fortunately, there is an upside to the interest rate hike. Soon after the BoC adjustment, HSBC announced it was boosting the rate paid on its high interest savings account to 5%. Stewart expects more financial institutions, especially ones like Dundee, Manulife Bank and ING Direct to follow HSBC’s lead.

“It seems to be a pretty competitive asset,” he says. “HSBC’s 5% option is going to put a lot of pressure on independent banks to raise rates.”

And that’s good news, especially for Stewart’s clients. “This has become a very popular asset class,” he says. “It’s one we’re using. It’s an interesting alternative to bonds because you’re not going to have the same kind of volatility.”

But anticipation of the hike might have had a negative effect on the housing market, as housing starts decreased 4.12% in June from last May. The biggest drop came in Ontario, where urban starts decreased by 19.4%.

Clients with variable mortgages could also feel the effects of a higher interest rate, says Stewart, but only if rates increase further.

“This doesn’t affect mortgages that greatly,” he says. “If it goes up one point, that would have a tremendous impact on people’s ability to pay mortgages, which I think would have drastic long-term effects on the economy.”

While the Bank of Canada’s rate hike isn’t a major one, some people might nevertheless be affected by it. It may be a good time to reevaluate some clients’ finances.

“If 25 bps affects a client’s financial life or goals in a major way, they need to address whether they have relevant or realistic long-term goals,” says Stewart.

Filed by Bryan Borzykowski, Advisor.ca, bryan.borzykowski@advisor.rogers.com

(07/10/07)

Bryan Borzykowski