My Five Key Mortgage-Rate Questions in Response to the Bank of Canada’s Surprise Overnight Rate Cut

The Bank of Canada (BoC) shocked markets last Wednesday when it dropped its overnight rate by 0.25% as a defensive response to sharply lower oil prices.

In its accompanying statement the Bank said that there is “considerable uncertainty” about how the oil-price shock will affect the strength of our recovery. The most immediate impacts are expected to be negative, as oil-patch investment dries up and our import purchasing power weakens. The longer term benefits of a strengthening U.S. economy and a weaker Loonie will take longer to accrue, and are thus less certain.

Against this backdrop, setting monetary policy is a daunting challenge. The BoC must make adjustments today based on assumptions about how the economy will look in the future, but with so much interplay between many complex variables, this decision-making process necessarily involves a mix of both art and science.

The BoC said it believes that “the oil price shock increases both downside risks to the inflation profile and financial stability risks”, and the Bank now expects that our economy will take until “around the end of 2016” to return to full capacity, which is later than it had previously forecast. Its rate cut is being used as a way to “provide insurance against these risks”.

The market’s initial response was as one would expect. Both the Loonie and our bond yields moved sharply lower as investors priced in a slower growth forecast for our economy as well as a more benign inflation outlook.

Normally when the BoC drops its overnight rate our major banks respond by dropping their prime rates, which our variable mortgage rates are priced on, but that didn’t happen this time. Instead, TD bank announced that it would not drop its prime rate and the other major banks quietly followed its lead. Interestingly, Rob Carrick at the Globe and Mail reported that TD did cut the rate that it pays on its investment savings account from 1.25% to 1.00%, thereby padding its margin by .25%. This proves yet again that it is better to invest in the Big Six banks than to borrow from them.

The decision by the major banks not to pass on the BoC’s rate cut raises five key questions:

1. Given that the Big Six banks did not follow the BoC rate drop this time, does this mean that they will also stand pat if there are more cuts? If there is a reduced likelihood that variable-rate borrowers will save money when the overnight rate falls, should they still accept the risk that they will have to pay more if the overnight rate rises? Variable-rate borrowers have operated under the assumption that a BoC rate cut would automatically translate into a lower interest cost, as has been the case in all but the rarest of past circumstances, but this most recent decision by the Big Six challenges that widely held belief. For my part, now that the banks are essentially offering a ‘heads-I-win, tails-you-lose scenario’, I think that variable-rate mortgage options are far less compelling.
2. Will the BoC put pressure on the major banks to lower their prime rates, since the impact of its overnight rate cut will be greatly reduced without this follow through? Interestingly, as things now stand, the BoC’s rate cut appears more likely to cause five-year fixed mortgage rates to fall, in response to falling Government of Canada (GoC) bond yields, instead of five-year variable rates as one would normally expect.
3. Will the BoC drop its overnight rate again in the near future? Since changes in the direction of monetary policy typically involve a series of incremental rate adjustments, are more BoC rate cuts on the horizon? And if so, how low will the overnight rate go? The markets are now pricing in 50% odds of another cut to our overnight rate sometime in the middle of 2015.
4. If the BoC’s overnight rate cut spurs a rise in housing market activity and we see an uptick in household borrowing, will this trigger a fifth round of mortgage-rule changes from federal finance minister Joe Oliver? While he says that more changes are not being considered at this time, you can be sure there is a backup plan sitting on his desk just in case.
5. Was the BoC’s overnight rate cut even intended to spur consumption or was it really just a way to drive down the Loonie? The federal government is loath to launch a far-reaching fiscal stimulus plan when its focus is on trying to balance its budget in an election year, so is the BoC using monetary policy to compensate for a failed fiscal response to a weakening economy in the same way that the U.S. Fed has done for the U.S. federal government over the past several years?

For me, the BoC’s out of the blue rate-cut announcement conjured up the image of a doctor using a defibrillator to shock a patient in cardiac arrest. This raises another question: will the Bank’s surprise move alarm Canadians and cause them to batten down their budget hatches rather than inspire them to open their wallets and ramp up spending? Might the BoC’s decision become a cautionary tale about the law of unintended consequences in the fullness of time?

Stay tuned to find out. You can be sure I will be watching carefully.

Five-year GoC bond yields fell through the floor last week, falling thirty-four basis points to close at 0.76% on Friday (a new all-time low). Lenders are gradually dropping their fixed-mortgage rates, but most continue to adopt a wait-and-see approach to the recent bond-yield volatility. Five-year fixed-rate mortgages are offered in the 2.79% to 2.69% range, depending on the terms and conditions that are important to you, and five-year fixed-rate pre-approvals have dropped to 2.89%.

Five-year variable-rate mortgages are still available in the prime minus 0.65% to prime minus 0.80% range.

The Bottom Line: The BoC’s decision to drop its overnight rate confirms that the Bank is quite concerned about the negative impacts that sharply lower oil prices will have on our economy. This new and significant headwind for our overall economic momentum implies that our fixed-mortgage rates should move lower, at least if GoC bond yields stay anywhere close to their current levels. Meanwhile, variable rates should stay stuck where they are for as long as the major banks prefer to use the BoC’s rate cut to line their pockets, instead of ours.