04/21/2012 08:35 EDT | Updated 06/20/2012 05:12 EDT

Don't Get Too Comfortable -- Higher Rates Are on the Way

While this week's Bank of Canada policy meeting may not have reinforced the "put down the credit card!" message, it did reinforce the guidance that interest rates are going to start heading higher regardless. There are two main caveats to the Bank's revised outlook.

In the past couple of weeks, the Bank of Canada has warned Canadians that it will play the bad parent if their debt-hungry ways didn't change -- threatening to use its monetary policy toolbox if necessary.

Considering that policy is supposed to target inflation, this stance was both surprising and maybe shocking for Canadians. If you recall, there was a heavy debate about a decade ago as to whether central banks should target asset values in addition to inflation, such as the prices of homes or the value of the stock market.

The verdict among economists was and still is that this would be a bad idea, so I can imagine what the thinking would be on the notion of a bank targeting debt levels. Now flash forward to this week's Bank of Canada policy meeting. While the outcome (i.e. policy statement) may not have reinforced the "put down the credit card!" message, it did reinforce the guidance that interest rates are going to start heading higher regardless. In what was a decidedly hawkish statement, the Bank commented that economic conditions have improved beyond what their economists had expected back in January, and that's not just Canada.

The view on the U.S. has firmed up ("profile for US growth is slightly stronger") and surprisingly, even the outlook on Europe has been elevated with the forecast calling for an end to recession in the region in the second half of this year. That seems to be a bold prediction in my opinion, especially in light of the recent back-up in bond yields for countries like Spain and Portugal; however, activity in "core" Europe has been more resilient.

On the Canadian front, confidence among households and businesses is ramping up quicker than the Bank had predicted, alongside improvement in the U.S. Somewhere between the lines I would imagine Bank officials have been buoyed by the latest surprise employment figures.

Yet, the key item from the Bank's statement is in the guidance section, where the Bank now expects excess capacity in the economy to be taken up by first half of 2013. In other words, a year from now.

Given that monetary policy works with a lag, if the Bank fully believes Canada's economy will be operating at full capacity in a year's time, it will need to start tightening policy before that. Timing will be vague at the start, as seen in the last paragraph ("...some modest withdrawal of the present considerable monetary policy stimulus may become appropriate," and "the timing and degree of any such withdrawal will be weighed carefully against domestic and external economic developments").

There are two main caveats to the Bank's revised outlook. One is the risk posed from higher energy prices. Even though gasoline futures have subsided since the end of February, pump prices remain sticky heading into the high-demand season and threaten households where incomes aren't keeping pace with general inflation, let alone non-discretionary items like gasoline.

The other risk harks back to my opening remarks and that is the elevated debt burden being shouldered by Canadians. If short-term rates were to move higher, we are talking about double-digit increases in variable interest rate borrowing costs (those that are tied to the prime rate, which is often directly related to changes in the Bank of Canada's official rate).

I would expect that if we remain on the present trajectory and there are no major financial shocks from left field, that we could be looking at the first official rate hikes by the fourth quarter of this year.

December futures are now pricing in one to two hikes, which would take the overnight target rate to 1.25 per cent or 1.5 per cent. No surprise then that we saw Canadian government bond yields spike today (two year yield now approaching 1.4 per cent) and this also played into a stronger Loonie (now more than a penny above parity).

For those of you thinking it might be a good time to lock in a mortgage -- yes, that thinking would be about right. As for investment strategies, a rising rate environment could cause your bond portfolio to experience capital loss, especially if the maturities of those bonds are long-term on average. Now would be a good time to re-examine the make-up of your portfolio, in addition to checking for those equity market sectors that are more sensitive to rising interest rates.