There are plenty of economic indicators investors watch closely, including inflation, unemployment, gross domestic product (GDP) growth, consumer spending, and corporate earnings. Each provides a different perspective on the health of the economy.
But few attract as much attention as interest rates. Every Bank of Canada announcement generates speculation about which investments will benefit, which will suffer, and whether investors should reposition their portfolios.
There are legitimate reasons to adjust a portfolio, such as approaching retirement. But for a long-term investor already in place, the next interest rate announcement usually isn’t one of them. Here’s why most would be better off ignoring the noise.
How Interest Rates Work
Interest rates represent the cost of borrowing money or the compensation lenders receive for providing it. In Canada, the Bank of Canada influences short-term borrowing costs by setting its target for the overnight interest rate. This affects the rates financial institutions charge one another and, indirectly, the rates consumers and businesses pay on mortgages, loans, and other credit products.
The central bank uses monetary policy to pursue its inflation target of 2%, the midpoint of a 1% to 3% control range. When inflation is running too high, raising interest rates can discourage borrowing and spending, slowing economic activity. Conversely, when economic growth weakens and inflationary pressures ease, lowering rates can encourage borrowing, investment, and consumption.
Which Investments Benefit or Suffer?
In general, rising interest rates tend to hurt investments whose value depends heavily on distant future cash flows. Long-maturity bonds are a classic example. Because their fixed coupon payments become less attractive when newly issued bonds offer higher yields, their market prices typically decline as comparable interest rates rise.
Interest-rate-sensitive stocks can also struggle. Utilities and real estate investment trusts (REITs), for example, often carry substantial debt. Higher borrowing costs can pressure profitability, while more attractive bond yields may reduce demand for their dividends. Growth stocks can face similar pressure because higher discount rates reduce the present value of earnings expected far into the future.
On the other hand, savers generally benefit from higher short-term rates. High-interest savings accounts and money market funds can offer better yields. Some financial companies, including banks, may also benefit under certain conditions, although the relationship is complicated. Higher rates can improve investment income or lending margins, but they can also increase funding costs and credit losses.
When interest rates fall, many of these relationships tend to reverse. Existing long-duration bonds may appreciate, borrowing costs decline, and interest-rate-sensitive businesses can receive some relief. These are useful general tendencies, but they’re far from guaranteed. The reason interest rates are changing often matters as much as the direction.
Why I’d Avoid Changing My Portfolio
Personally, if I already owned a globally diversified portfolio of low-cost exchange-traded funds (ETFs), I wouldn’t make major allocation changes simply because the Bank of Canada raised or lowered rates.
Interest rates have fluctuated enormously throughout modern financial history. Canada’s overnight rate reached approximately 21% in 1981 as policymakers battled inflation. Decades later, the Bank of Canada reduced its policy rate to 0.25% during the 2020 pandemic.
Those are radically different monetary environments, yet long-term equity investors have still benefited from the growth of businesses, technological innovation, and reinvested corporate profits across multiple economic cycles.
Of course, the path hasn’t been smooth. Stocks have experienced major crashes, prolonged bear markets, and periods of disappointing returns. But that’s precisely why I prefer diversification over trying to predict the next rate cycle.
There’s also a practical problem with reacting to interest rate announcements: financial markets are forward-looking. By the time the Bank of Canada announces a rate change, bond yields and stock valuations may already reflect investors’ expectations.
Markets often respond more to how a decision differs from expectations than to the decision itself. For example, a rate cut might sound bullish for stocks, but if it occurs because the economy is deteriorating faster than expected, equities could still decline.
Therefore, I think the best move is to do nothing and maintain a diversified asset allocation appropriate for your investment horizon and risk tolerance, keep fees low contribute regularly, reinvest distributions, and rebalance periodically.
