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Be prepared for Bank of Canada to raise interest rates

For months the consensus has been that interest rates in Canada would remain stable right into 2018. Now Bank of Canada governor Stephen Poloz and his colleagues are dropping broad hints that the central bank will move a lot sooner, perhaps as early as next Wednesday’s meeting.

The loonie has responded accordingly, topping $0.77 (U.S.) on June 30 for the first time in more than a year. There could be even more upside for our embattled currency if the bank doesn’t stop at a single hike.

History strongly suggests it won’t:Once the policy-makers turn hawkish they tend to stay that way for a long time.

Look back to 2004. The bank determined that our economy was sufficiently recovered from the recession of 2000-2002 to withstand an interest-rate increase of 0.25 per cent in September. That raised the Bank Rate from 2.25 per cent to 2.50 per cent.

Over the next four years, the rate was raised another nine times, reaching a peak of 4.75 per cent in July 2007. The total increase over that period was 2.5 percentage points, meaning the rate had more than doubled.

Commercial rates reflected the moves of the central bank. Mortgages became more expensive – between March 2004 and January 2008 the average five-year mortgage rate increased from 5.3 per cent to 6.8 per cent, a jump of more than 28 per cent.

While homeowners with variable rate mortgages faced escalating costs, savers were rewarded. The average rate on a five-year GIC increased from 2.25 per cent in March 2004 to 3.60 per cent in July 2007. It has never been anywhere near that level since.

All this suggests we should be prepared for a string of rate increases starting this year and continuing through 2018 and perhaps longer, depending on economic conditions. The circumstances aren’t absolutely right for this – inflation, for example, is running well below the Bank of Canada’s target at 1.3 per cent and unemployment in May increased slightly to 6.6 per cent. But GDP is rising and the bank’s governors seem to feel it will continue to do so, despite weak oil prices and trade uncertainties with the U.S., so we’d be smart to prepare for a series of increases. Here is what I suggest you do.

Lock in your mortgage: Anyone with a variable rate mortgage is vulnerable when interest rates start to move higher. Unless you are comfortable with a quarter-point increase in your rate every few months for the foreseeable future, I suggest you lock in to a three- or five-year fixed term now.

Don’t commit to long-term term GICs: Why would you tie up your money for five years at a low rate when you know you could get more six months or a year down the road? Right now the Royal Bank is offering 1.6 per cent on a five-year term. If the interest rate pattern unfolds as we now expect, you would probably be able to earn 2 per cent or higher in 12 months.

Expect weakness in interest-sensitive stocks: When rates rise, investors demand higher yields for holding riskier assets such as stocks. We saw evidence of this as soon as Bank of Canada officials started hinting at higher rates. During the last week of June, the S&P/TSX Capped REIT Index fell 1.74 per cent while the Capped Utilities Index was off 1.66 per cent and the S&P/TSX Dividend Composite Index was off 0.83 per cent. That trend is likely to continue as interest rates are pushed higher. Income-oriented investors are likely to see some erosion in the value of their equity portfolios as a result. However, you’ll still receive regular dividends/distributions and better yields on new investments.

Stay short-term with bonds: Bond prices decline when interest rates rise. The longer the term to maturity the more vulnerable a bond is in this environment. That doesn’t mean abandoning bonds altogether, but stick to short-term securities or the funds that invest in them. If you do experience losses they will be small.

Don’t bet against the loonie: Six months ago there were predictions that our dollar could fall as low as $0.70 (U.S.). That was predicated on the assumption that the Bank of Canada would sit on its hands until at least mid-2018. The recent rise of the loonie, even in the face of soft oil prices, indicates the strong impact of rate hikes (or the anticipation of them) on our currency. If we are in for a string of rate increases, as history suggests, than a $0.80 (U.S.) loonie is well within the range of possibility.

We have lived in a historically low-interest environment since spring 2009, when the Bank of Canada overnight rate fell to 0.50 per cent. It now looks like that eight-year run is drawing to a close.

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