Recently, Canada’s inflation rate hit a low of 3.4% — the lowest since the inflation spike of 2022. Nevertheless, the Bank of Canada has signaled that there many be more interest rate hikes to come. 3.4% inflation is much lower than what was seen last year but still higher than the bank’s target, which is 2%. If Tiff Macklem really wants to get inflation under control, then another rate hike or two may be needed.
The question investors need to ask themselves here is how this will affect their portfolios. In theory, interest rate hikes reduce the value of investments, as they increase the opportunity cost (the value of what you give up) of any series of cash flows. However, there are some types of stocks and bonds that can do pretty well in periods when interest rates are going up.
Why the Bank of Canada is raising interest rates
The reason why the Bank of Canada is raising interest rates is because inflation in Canada has been persistently high for more than two years. In 2022, inflation briefly went over 6%. That is to say, the price of the basket of goods in the Consumer Price Index (CPI) went up six percentage points. That is far higher than the Bank of Canada’s inflation target.
In order to get inflation down, the Bank of Canada began raising interest rates in mid-2022. High interest rates reduce economic activity by increasing the cost of borrowing. If you buy $5 worth of goods on a credit card at 10% interest, you pay $0.50 in interest if you do not pay off the balance. If you buy that same amount of goods at 20% interest, then you pay $1.
Because interest rates increase the cost of credit, they should theoretically slow the pace of increases in the list price (price not factoring in financing) of goods. We have indeed seen this happen; inflation has been cut by nearly a half since the Bank of Canada started raising rates.
The problem is that high interest rates tend to reduce the value of investments. When it becomes expensive to buy stocks on margin, less people are able to buy stocks. Also, stocks become less appealing relative to the increasingly high-yielding treasuries that become available when rates rise. So, high interest rates tend to be bad for stocks.
Stocks that can do well when interest rates are high
In theory, a higher interest rate should produce lower stock prices, all other things the same. However, that’s not exactly what has happened this year. Stocks have actually rallied in 2023, despite multiple interest rate hikes by the Federal Reserve and Bank of Canada. It’s not clear why this is happening; it could be that investors just think last year’s selloff was overdone.
Sometimes bank stocks can do well when interest rates rise. Take Royal Bank of Canada (TSX:RY) for example. It’s a Canadian bank involved in savings, loans, investment banking and insurance.
The higher interest rates go, the higher the rates Royal Bank charges on credit cards and mortgages. So far this year, rate hikes have had a positive impact on Royal Bank’s net interest income (NII). NII is a bank-specific profit metric that means loan interest earned minus deposit interest paid. Banks have been collecting higher NII this year due to high interest rates. However, this isn’t guaranteed to last. The yield curve is inverted, meaning that banks may end up spending more on interest than they collect. This is always a risk with inverted yield curves, but so far, it hasn’t stopped RY from earning a nice margin on its loans.
