The Bank of Canada affects short-term interest rates by hiking or reducing the overnight rate target. In turn, large banks borrow and lend overnight funds to one another at the overnight rate.
Increasing borrowing costs
You can imagine that the higher the rate the large banks borrow and lend to each other at, the higher the rate of other loans such as commercial loans, consumer loans, and mortgages.
Alluding to more interest rate hikes
In the last 10 years, the target for the overnight rate had been as low as 0.25% and as high as 4.5%. In July, the Bank of Canada hiked the overnight rate target by 0.25% to 0.75%.
The recent economic data was so strong that the Bank hiked the rate by 0.25% again to 1%, and if the economy continues to do well, we will see another 0.25% hike by the end of the year.
Effects on the real estate sector
The major concern, of course, is the historically high household debt, which is high largely due to mortgages. However, the mortgage rates are similar to the levels we saw a year ago, which are still relatively low to historical levels.
So, refinancings that will occur within the next 12 months shouldn’t see a huge impact. That said, these rate hikes will probably cool down the housing prices further, particularly in Toronto and Vancouver.
Real estate investment trusts (REITs) such as Canadian Apartment Properties REIT (TSX:CAR.UN), Allied Properties Real Estate Investment (TSX:AP.UN), and RioCan Real Estate Investment Trust (TSX:REI.UN) may see dampened growth as REITs have large levels of debt.
That said, these three stocks have the strongest balance sheets in their respective industries of residential REIT, office REIT, and retail REIT.
Utilities, which tend to have large levels of debt, may experience some dips in their stock prices in light of rate hikes. They include Fortis Inc. (TSX:FTS)(NYSE:FTS), Canadian Utilities Limited (TSX:CU), Emera Inc. (TSX:EMA), and Algonquin Power & Utilities Corp. (TSX:AQN)(NYSE:AQN). However, they may still make sense as holdings in long-term portfolios due to their decent yields, stability, and growing dividends.
Insurance companies and banks, such as Manulife Financial Corp. (TSX:MFC)(NYSE:MFC) and Toronto-Dominion Bank (TSX:TD)(NYSE:TD) should benefit from rate hikes. Manulife will earn more income from its fixed-income portfolio. For TD Bank, its net interest margin will improve.
If you invest in REITs and utilities, it makes sense to review your portfolio and reposition it to focus more on ones with lower levels of debt and higher growth potential compared to its peers.
If you’re underweight in the insurance companies or banks, now is a good time to buy some shares before the next interest rate hike.
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Fool contributor Kay Ng owns shares of ALGONQUIN POWER AND UTILITIES CORP. and EMERA INCORPORATED.