The Bank of Canada (BoC) raised its policy interest rate by 0.25% to 2.50% on October 28, marking its first hike since 2023. While higher borrowing costs can pressure consumers and businesses, the move could also create opportunities for Canadian bank stocks. But should investors view rising rates as a reason to buy bank shares or a warning to take profits?
The answer depends on more than interest rates, including the consideration of valuations, economic growth, and potential credit losses.
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Higher rates can boost bank earnings, but there’s a catch
Canadian banks generally benefit from rising interest rates because higher lending rates can improve net interest margins and boost investment income. Gradual increases can also help prevent excessive borrowing and support financial stability.
BoC Governor Tiff Macklem explained that the latest hike aims to prevent elevated global oil prices from spreading into broader inflation. The policy rate is low enough not to restrain economic growth while helping return inflation to its target more quickly. Another increase remains possible if inflation proves persistent.
However, higher rates are not an automatic win for banks. More expensive mortgages, loans, and credit-card balances can strain household finances, potentially increasing defaults and weakening loan growth. Banks need a reasonably healthy economy to translate higher interest rates into sustainable earnings growth.
Economic weakness and expensive valuations raise the stakes
Canada’s economic outlook adds uncertainty. Growth has been cooling, and new U.S. Section 338 tariffs, imposing 50% levies on targeted Canadian goods such as autos, dairy, electronics, and alcohol, alongside Canadian countermeasures, could weigh further on business activity.
The BoC estimates gross domestic product (GDP) growth of approximately 1.0% to 1.1% in 2026, with a potential rebound toward 2.0% in 2027 as business investment strengthens and inventory pressures fade. Although this suggests a gradual recovery, investors should not overlook the near-term risks.
Valuation is another concern. Consider, as an example, Toronto-Dominion Bank (TSX: TD), trading at about $174 per share at the time of writing. Its price-to-earnings (P/E) ratio of around 17.2 is roughly 50% above its historical averages over the past 5, 10, and 15 years. The premium reflects expectations of strong earnings growth, forecast at approximately 11% annually over the next couple of years.
Those expectations leave less room for disappointment. If economic conditions deteriorate, rising provisions for credit losses could erode earnings and trigger a share-price correction. Even an excellent bank can become an expensive investment when investors pay too much for its future growth.
Buy, hold, or trim? It’s a balancing act
Canadian banks remain high-quality businesses with established franchises, diversified revenue streams, and long-term earnings potential. Rising interest rates alone do not make them investment traps. However, buying at elevated valuations exposes investors to greater downside if earnings disappoint or credit conditions weaken.
TD is a good example here. Its shares have appreciated nearly 125% over the past three years. Investors who bought earlier have benefited substantially, but those gains may also have left TD representing an oversized portion of their portfolios.
Rather than chasing further gains, investors could consider trimming a portion of their holdings to lock in profits and restore portfolio balance. For instance, an original 5% position might have grown to 10%. Trimming it to 7.5% to 5% might make sense depending on your portfolio composition and risk tolerance. New investors, meanwhile, may benefit from waiting for more attractive valuations instead of buying solely because rates are rising.
The Foolish takeaway
Higher interest rates can support Canadian bank earnings, but they do not guarantee higher stock returns. With economic uncertainty and historically elevated valuations, investors should focus on price, credit quality, and portfolio diversification. The opportunity is not simply to own Canadian banks, but to own them at sensible prices and in appropriate proportions.
