After almost a decade near historical lows, Canadian interest rates are on the rise.
The Bank of Canada, after cutting its policy rate sharply during the late-2000s financial crisis and again during the commodity collapse of 2014-16, has now rolled out a series of rate hikes.
Longer-term interest rates are also trending higher, with the five-year Government of Canada bond yield rising from an all-time low near 0.6 percent in early 2016 to over two percent at present.
Interest rates also have further to rise — at least, absent an unexpected deterioration in economic conditions — as the Bank of Canada’s current policy rate of 1.75 percent remains well below levels considered neutral for the economy (roughly 2.5 percent). With the unemployment rate near four-decade lows and inflationary pressure building, the need for stimulative interest rates has clearly faded. However, we expect the Bank of Canada to tread cautiously as it continues to tighten policy because raising rates abruptly would risk derailing the economy, particularly given today’s elevated levels of household debt and high housing market valuations in major cities.
All told, we believe the Bank of Canada is likely to reach neutral territory in the first half of 2020 and that the five-year Government of Canada yield will level off near three percent around the same time. That said, rates could rise further and faster if the economy showed signs of overheating.
Although interest rates are expected to increase only gradually, the situation nevertheless bears monitoring on the part of farmers, who will be affected through a number of channels. Most directly, higher interest rates will mean higher financing costs. This effect will be felt almost immediately by producers who have borrowed at a variable rate or over a relatively short term, and more gradually by those with longer-term, fixed-rate financing.
Across the agriculture sector as a whole, debt outstanding has more than doubled since the mid-2000s, so rising interest rates will likely weigh more heavily on farm finances than in the past. Although the cost pressure should be manageable for most producers, it will present a greater challenge for highly leveraged operators.
Rising interest rates also have the potential to affect farmers indirectly. By making Canadian financial assets more attractive to foreign investors, higher rates are expected to put upward pressure on the Canadian dollar, whose low level has been a boon to the agriculture industry over the past few years. Although loonie appreciation is expected to play out only gradually, it will nevertheless represent a headwind for Canadian agricultural prices and farm revenue.
Higher interest rates also have the potential to erode the price of farmland, which has roughly tripled over the past two decades, by increasing its carrying cost and diminishing its net earning potential.
Overall, rising interest rates are not something most farmers should lose sleep over, but vigilance is crucial. As always, but especially at this stage in the cycle, we are emphasizing caution when we talk to our agriculture customers.
Specifically, we are giving them the following recommendations:
- Lock it in: Evaluate the merits of locking in rates for longer terms to bring predictability to cash flows. Changing weather and rising interest rates create significant uncertainty; locking in rates may help farmers better handle external headwinds.
- Harvest efficiencies: Farm operators have a lot of opportunities with new technologies to find ways to drive greater efficiency. The upside is that improved efficiencies in farm operations will improve profitability and cash flows and leave farmers better able to handle rising interest rates.
- An extra farm hand: When interest rates are on the rise, farmers need to speak to their financial advisers like their bank relationship managers. Depending on how high the rates are rising, it might still be an attractive time for them to invest in their operations if the investment results in improved profitability and cash flow, particularly if rates are expected to rise further over the course of the coming year. Farmers need strong relationships with their advisers. This helps an adviser find solutions most likely to fit particular circumstances.
Adam Vervoort is the national manager of agriculture for BMO.