Welcome to the Jurassic economy.
No dinosaurs, but we now see monsters thought to be dead and buried. Inflation ravages the land. Compared with just a year ago, interest rates have grown to mammoth proportions.
The rate environment is evolving quickly, which puts an onus on borrowers, savers and investors to be more active than usual in managing their finances. As good a place as any to build an understanding of what’s driving rates today is the overnight rate set by the Bank of Canada.
The overnight rate itself is of little concern to anyone outside banking. It’s used as a rate for big financial institutions borrowing money from each other as part of daily money flows around the banking system. What matters to individuals is whether the overnight rate is stable or changing.
The Bank of Canada sets out specific dates for announcing changes, if any, to the overnight rate and you can follow them online. Starting with July 13, there will be four rate settings in the second half of 2022. These dates are important if you have floating-rate debt, which is to say a loan, line of credit or mortgage where the cost of borrowing isn’t fixed for the duration of your payback period.
Changes in the overnight rate are mirrored within hours by adjustments to the prime lending rate at banks and other financial players, which is used to price floating-rate debt.
The prime itself is a rate reserved for a small elite among reliable borrowers. Lines of credit secured by home equity are often priced at prime plus 0.5 of a percentage point, while non-secured credit lines and loans would have a much more substantial markup because they’re riskier from a lender’s point of view.
Mortgages are the safest type of lending, so variable-rate mortgages can be offered at prime minus a serious discount. In mid-2022, some mortgage brokerage companies offered prime minus 0.9 of a point.
Much attention is paid to the overnight rate because it reflects the Bank of Canada’s view of inflation and the economy. An increase means inflation’s too hot, no action means the status quo is working and a decrease suggests concern that the economy needs a jolt to increase growth.
The overnight rate is also a factor for banks in setting the rate on their savings accounts. Banks use money in savings to lend out at higher rates – that’s where they make a part of those billion-dollar profits. Savings rates vary widely among banks because each has a different idea of a profitable spread between interest rates paid out and rates received from clients who borrow.
The unseen hand in setting rates for borrowers and savers is the bond market. Example: The interest rate on bonds issued by the federal government and maturing in five years have a big role for lenders in setting rates for five-year fixed mortgages and five-year guaranteed investment certificates.
The yield on the five-year Government of Canada bond touched 3.5 per cent in mid-2022 after starting the year around 1.3 per cent. This helps explain why five-year fixed-mortgage rates pushed higher over the same period.
GIC rates have climbed as well, but with wide differences between financial players. Alternative banks typically increase their GIC rates further and faster to attract money away from competitors, while big banks may be intermittently competitive on rates.
The yield on bonds moves in the opposite direction to bond prices. Now you understand why the price of your bonds and bond funds has been falling as interest rates rise. When interest rates come back down, the price of bonds will start to rise again.
Credit card interest rates are unaffected by what’s happening in the economy and financial markets from month to month and year to year. A typical credit card interest rate today is 20 per cent – that’s what card issuers feel they need to charge people with unpaid credit card balances in order to offset the cost of missed payments and fraud, as well as reward programs and operational expenses. There are low-rate credit cards, but their cost of borrowing is still about 13 per cent.
This Jurassic period in our economic history will end when inflation retreats and interest rates stabilize and turn lower. Understanding how and why rates move will help you survive these exceptional times. May we not see them again for eons.
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