What happened?

The central bank’s key overnight interest rate increased by 0.25% from 1.25% to 1.50%. The key rate can affect Canadian banks’ prime rates, which would then affect variable-rate mortgages and other variable-rate loans.

Surprise or widely expected?

Widely expected (though not universally endorsed). While still accommodative, the Bank of Canada signaled in May that with a tight labour market, higher rates would be warranted to keep inflation near its target over the coming quarters. The overnight index swaps market indicated a probability of 90% in the days prior to the announcement, according to Thomson Reuters.

Implications for bonds?

The central bank had already raised rates three times since July 2017 (each time by 0.25%). In general, rising rate environments pose a challenge to bond investors. However, while shorter-term bond yields tend to be closely linked to the Bank of Canada’s policy rate, longer-term bond yields are influenced by a broader range of factors, including expectations for future economic growth and inflation.

At this time, there are potential headwinds to the Canadian economy (slowing real estate, consumer debt, NAFTA) that can reduce growth and inflationary pressures and therefore may provide upside potential for bond returns.

Implications for housing?

The pace of growth in real estate prices has levelled off, according to a July report by Royal LePage: the national house price composite showed a year-over-year increase of 2% in the second quarter. In general, interest rate increases reduce affordability and raise the cost of borrowing, thereby suppressing house price appreciation.

And with Canadian consumers having relatively high debt obligations relative to their disposable incomes, the increase could further dampen both real estate and consumer spending. It may also hold back Canadian equity returns by potentially reducing profit growth for financials, which comprise over one third of the S&P/TSX Composite Index.

Implications for Canadian dollar?

In general, higher interest rates can increase the value of a nation’s currency, but they are only one of many factors. When markets anticipate interest rate increases, currency may rise prior to the actual announcement. Overall, however, the Canadian dollar has fallen versus its U.S. counterpart in 2018.

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