FCC Says Interest Rates Are On The Rise: What’s Your Risk Tolerance?

As interest rates slowly rise from their historic lows, we want to help pump up your farm financial fitness. Throughout March, we’ll be sharing posts to help put your 2018 farm financials into the larger Canadian context and explain key financial tools as you go. Check back weekly to see where Canadian ag is going and how you can stay ahead

by Craig Klemmer – Farm Credit Canada (FCC)

Expected increases in interest rates throughout 2018 will lead to more questions about the benefits and drawbacks of fixed versus variable rate loans. Here’s what you need to know to make the right decision for your operation.

“Economies around the world are recovering … and interest rates are climbing as a result”

 

Many economies shrank due to the 2008 financial crisis, forcing governments to provide significant stimulus to minimize its impacts. In Canada and many other developed markets, this meant lower interest rates.

After 10 years of flat or declining interest rates, borrowing costs are now climbing as the world economy shows signs of sustained growth. The Bank of Canada (BoC) forecasts U.S. economic growth of 2.6% in 2018, while the European Union will grow 2.2%. The Canadian economy is forecast to expand 2.2% in 2018, after growing an estimated 3.0% in 2017.

That could mean higher interest rates for your business. And with farm revenue expected to remain flat for 2018 , you should know how sensitive your operation is to further interest rate increases. One way to mitigate financial risk is to choose the right interest rate product for you: variable or fixed.

BoC decisions drive variable rates

The prime lending rate (the annual interest rate Canada’s major banks and financial institutions use to set interest rates for variable loans) is currently 3.45%. As the Bank increases the interest rate they charge lenders (the “overnight” rate), the prime rate and your variable rate will increase.

The business prime rate is currently 1.95% higher than the overnight rate on the basis of a strong Canadian economy and labour market.

Interest rates forecast to trend higher in 2018

Financial markets expect the BoC to increase rates another 25 to 50 basis points in 2018. The U.S. Federal Reserve is expected to increase rates by 75 basis points in 2018, with the first rate hike expected March 21.

The bottom line? Borrowing costs could easily continue climbing in 2018.

Fixed rates higher due to domestic and international bond markets

With the BoC expected to raise interest rates, you may choose to lock in rates on new, or existing, debt. While longer-term mortgages usually offer higher interest rates, locking in can avoid problems associated with a variable rate loan’s future rate increases. One advantage to fixed rate products is the predictability of your repayments for a set period. That’s important in a year of flat revenue growth.

Unlike variable rates, determining the rates for fixed-rate loans is complex, as they’re derived from many influences, including global and domestic bond markets.

The cost of a locked-in five-year mortgage reflects the lender’s costs to access funds in the bond market. Interest rates on a one- or five-year term vary. Within a growing economy, interest rates on short-term bonds are usually lower than rates on long-term bonds.

Understanding your risk tolerance to rate increases is the first step to take. It also makes sense to monitor changes in the BoC rates and broader economic trends. An optimistic outlook for the economy is bound to push interest rates higher throughout 2018.

How do you measure the impact of interest rates on your working capital and capacity to meet debt obligations? Our next blog post will look at the influence of movements in interest rates on financial ratios.

Craig Klemmer is the Principal Agricultural Economist with Farm Credit Canada. He joined FCC in 2009 as an Agricultural Economist, specializing in monitoring and analyzing the macroeconomic environment, modelling industry health, and providing industry risk analysis. Prior to FCC, he worked in the livestock branch of the Saskatchewan Ministry of Agriculture. Craig holds a Master of Agricultural Economics degree from the University of Saskatchewan.