Economic analysis

Grandpa, what’s an interest rate hike?

A generation of workers and borrowers have grown up never knowing that interest rates can also go up. They’re about to learn what it feels like.


If the past few months have taught us anything, it’s that things that seem impossible sometimes happen. Britain would never give up membership in the European Union, four decades after first joining the common market, until it did. The U.S. would never elect a buffoonish, white-supremacist-dog-whistling, chronic business failure turned reality-TV star to the White House, until it did. Both events spectacularly confirmed the folly of conventional thinking. And in the world of finance, if there’s one idea that came to be widely accepted over the course of the past decade, it was that the world is now in a permanent state of slow growth, a so-called “new normal” that will require rock-bottom rates to prop it up indefinitely. In this new world, substantially higher interest rates might never be seen again.

Well, as Ed Yardeni, a veteran analyst on Wall Street noted the other day, “Just as everyone was reading the last rites for the ‘old normal,’ it seems to be making a comeback.”

Yardeni had an addendum to his comment: “at least in the U.S.” Yet there is no isolating the U.S. from the world, regardless of how high a fence Trump eventually builds on America’s southern border, or how many trade deals he tears up. What happens in the U.S. will be felt elsewhere, particularly by its closest trading partner to the north. Which means the prospect of higher interest rates in the U.S. and Canada is here, and the increase could come much faster than anyone expects.

A few factors are lining up to make money more expensive for Canadians to borrow in the coming year. The most profound is Trump’s election win. Trump has a promise to keep to those who delivered him to victory—to boost wages and drive down the unemployment rate. Never mind that at 4.6 per cent, unemployment is as low as it’s been since mid-2007. In Trumpland, joblessness “feels” higher, and Trump has vowed to respond with massive tax cuts and a US$1-trillion infrastructure plan. It’s precisely the type of fiscal stimulus that organizations like the International Monetary Fund had been calling for, and which beyond Canada had mostly fallen on deaf ears. Now massive deficit-driven fiscal stimulus is about to heat up the world’s largest economy. Long-term U.S. Treasury yields have spiked to a more than two-year high on expectations of higher inflation, and while the U.S. Federal Reserve responded with only its second rate hike in a decade earlier this month, the pace of future rate hikes in the U.S. may quicken.

Patrick Doyle/Bloomberg/Getty Images
Patrick Doyle/Bloomberg/Getty Images

Now, Bank of Canada governor Stephen Poloz certainly isn’t about to follow suit and raise the Bank’s target interest rate—in fact, several economists think he might still favour further trims. However, the impact of higher rates in the U.S. will be hard for Canadian mortgage borrowers to avoid. Fixed-rate mortgages are benchmarked against bond yields, and since early November, bond yields here have risen in tandem with the U.S.—the five-year Government of Canada bond yield has nearly doubled to 1.22 per cent. The pressure from higher bond yields comes as Canadian lenders are also grappling with new mortgage lending rules from Ottawa that make it harder for homebuyers with down payments of less than 20 per cent to qualify for a mortgage, while also making it tougher for lenders to access government-backed mortgage insurance. Already two banks, TD and RBC, have introduced higher mortgage rates in response to these powerful forces.

Less tangible but no less significant is a shift in mindset with regard to low interest rates. Nearly a decade of near-zero rates have failed to do what they were intended to do: revive growth and spark inflation. This has led to mounting calls for central bankers to take a different approach, based on the idea that low rates are restricting growth and leave no room for cuts when the next crisis hits. That idea got a high-profile voicing in early December when former Bank of Canada governor David Dodge called on the world’s central banks to coordinate rate hikes. What appeared impossible a year ago suddenly seems inevitable.

When rate hikes do come, they will deliver a shock to a very large number of people. A vast swath of today’s working population—and hence homebuyers—have no inkling of what higher interest rates look like. For roughly a third of workers in Canada, the last time interest rates were as high as even the lowly level of five per cent, it was 2001, when they were still in school—some in university, but a lot of them in kindergarten.

Yet lured by the promise of years of ever cheaper debt, Canadians have loaded up on car loans, mortgages and lines of credit backed by the swelling equity in their homes, positioning them perilously for even a small rate hike. Just this past fall, TransUnion, the credit-monitoring firm, revealed that one million Canadians would not be able to handle even a one-percentage-point increase in rates.

Which raises the spectre of another event that has long been deemed by finance experts as impossible in Canada—a sharp housing correction.