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Five Key Questions Relating to the Bank of Canada’s Latest Rate Cut

Monday Morning Interest Rate Update for July 20, 2015

by David Larock

toronto mortgage ratesLast week the Bank of Canada (BoC) lowered its overnight rate from 0.75% to 0.50% in an effort to counteract downside risks to inflation and weaker-than-expected overall economic growth.

The Bank also downgraded its projections for GDP growth to “just over 1% in 2015 and about 2 ½ per cent in 2016 and 2017”, and now projects that “the economy will return to full capacity and inflation to 2 per cent on a sustained basis in the first half of 2017”. Reading between the lines, that means that the Bank doesn’t expect to raise its overnight rate for about another two years.

I was surprised by the BoC’s decision for the reasons outlined in last week’s post. In summary, I thought that our policy makers would judge that our economy needed fiscal stimulus more than monetary stimulus in the current environment, and that they would worry that cheaper borrowing rates could further elevate our household borrowing rates, which the BoC has repeatedly flagged as the most significant domestic risk to our economy.

In the end, the Bank acknowledged this risk but felt that more monetary stimulus was required to help our economy continue its “significant and complex adjustment”.

In today’s post I’ll address five key questions relating to the BoC’s latest rate drop:

  1. How will the BoC’s latest rate cut affect variable mortgage rates?

When the BoC lowers its overnight rate, lenders normally reduce their prime rates in lockstep, and since our variable-rate mortgages are priced on lender prime rates, if the Bank drops by 0.25%, variable rates would typically be expected to fall by the same amount. But these are not normal times, as we saw in January, when the BoC cut its overnight rate by 0.25% and lenders lowered their prime rates by only 0.15% in response.

This time around, TD bank dropped by 0.10% almost immediately after the BoC announced its rate cut, hoping that its competitors would follow suit. But when its competitors chose to drop by 0.15% instead, TD quickly adjusted its pricing and fell back in line. As such, the BoC’s latest 0.25% rate cut translates into a reduction of 0.15% for variable rate borrowers, and most lenders will begin passing on that saving as of July 1.

  1. How does the BoC’s overnight-rate cut affect fixed mortgage rates?

Fixed-rate mortgages are priced on Government of Canada (GoC) bond yields, and as such, they are not directly correlated to the BoC’s overnight rate. That said, these bond yields are constantly adjusting to changes in inflation and growth expectations, so BoC rate cuts do have an indirect influence on fixed-mortgage rates, albeit through a longer and more convoluted feedback loop.

  1. Why did the BoC decide to cut its overnight rate?

The BoC has long said that a healthy Canadian economic recovery must be underpinned by rising export demand, which fuels increased business investment. A cheaper Loonie is a hoped-for way of kick starting this process.

While BoC Governor Poloz continues to claim that his Bank does not use its monetary policy to influence the Loonie, last week’s rate cut was designed to weaken it, pure and simple.

  1. Will the latest rate cut work?

Yes and no.

The latest overnight rate drop will certainly help weaken the Loonie, as we have already seen in the immediate aftermath but I think that it will do little to help stimulate our economy over the short and medium term.

For example, as I wrote last week, the most immediate impact of the weaker Loonie will be higher import prices and, by association, higher inflation rates. This impact was evident in our latest inflation data, released last week. Overall Canadian inflation, as measured by our Consumer Price Index (CPI), rose for the third straight month to 1%. Even more notably, core inflation, which strips out more volatile CPI inputs like food and energy and is seen by the Bank as a more accurate gauge of overall inflationary pressures, rose to 2.3%.

Also, while there is no debating that the cheaper Loonie will make our exports more competitive, our manufacturing sector will take more time than normal to capitalize on this incremental advantage because many of our exporters that either left or were wiped out by the combination of the Great Recession of 2008 and the surging Loonie that accompanied it.

While our export manufacturers can reasonably be expected to respond to the cheaper Loonie by ramping up production in anticipation of rising demand, today our manufacturing sector is a pale shadow of its former self and the benefits of the cheaper Loonie to our economy are therefore muted.

In Ontario alone, the list of manufacturing plants that have left is long, and they won’t be returning any time soon. Unfortunately, this process shows few signs of abating. Toyota recently announced that they will be moving the production of their largest selling car, the Corolla, from Waterloo to Mexico, GM has said that the future of its investment in Oshawa is unclear, and Windsor recently lost two competitions for major automotive manufacturing investments. The corresponding slowdown in the manufacturing of products for our ailing domestic oil industry, the impacts of which are only beginning to be felt, will only compound the current weakness in our manufacturing sector.

Bluntly put, we are now left to hope that many of the Canadian exporters that will be able to take full advantage of a cheaper Loonie are now in the process of being invented.

  1. What should our policy makers have done instead?

Having criticized the BoC’s decision to cut its overnight rate, I think it’s only fair to offer an alternative  view on what our policy makers should have done instead.

As I briefly mentioned above, I think that today our economy would benefit more from fiscal stimulus, in the form of increased federal government infrastructure spending. This type of shovel-ready stimulus would have a more immediate impact on our short-term economic momentum and would be more likely to spur the increased business investment in productivity improvements and capacity expansion that the BoC believes is so vital to a healthy and sustainable recovery. The BoC recognizes this but has no levers it can pull to make it happen because fiscal decisions are in the hands of the federal government.

Unfortunately, however, we are now in a federal election year and our current government appears determined to face the voters with a balanced budget this fall. Recognizing that fact, it is likely that the BoC cut rates in an effort to compensate for a lack of fiscal response.

It will be interesting to see how the federal government’s decision making, which, politics aside, appears increasingly dogmatic in the current environment, is evaluated by voters on election day.

Five-year GoC bond yields fell by nine basis points last week, closing at 0.71% on Friday. Five-year fixed-rate mortgages are offered in the 2.49% to 2.59% range and five-year fixed-rate pre-approvals are available at rates as low as 2.69%.

Five-year variable-rate mortgages are available in the prime minus 0.65% to prime minus 0.75% range depending on the terms and conditions that are important to you.

The Bottom Line: I think that the BoC’s rate cut will do little to stimulate our economy and may exacerbate the risks associated with household borrowing levels. Regardless, the 0.25% reduction in the Bank’s overnight rate has translated into another 0.15% drop in variable mortgage rates and most variable-rate borrowers will begin to enjoy that saving when lenders reset their rates on August 1.

David Larock is an independent full-time mortgage broker and industry insider who helps Canadians from coast to coast. If you are purchasing, refinancing or renewing your mortgage, contact Dave or apply for a Mortgage Check-up to obtain the best available rates and terms.
  1. Mike permalink

    Hi Dave,

    Thanks for your blog, I enjoy reading them and learning about mortgages, etc.

    I decided to go variable for the first time ever and so far quite happy I did. I’m curious about how the Banks Prime rates work though. Since most banks recently only lowered Prime rate by a portion of what the Bank of Canada lowered their lending rate (.15% instead of .25% in January and again this month), what will happen when the Bank of Canada decides to raise their rates by lets say .25%? Can Banks increase their Prime rate by the full .25%? or would they increase them by the amount they previously lowered their Prime (.15%)?

    I’m worried in the future that when the Bank of Canada finally increases their lending rate, the Banks will take advantage and use this as an opportunity to quickly increase their Prime rate quicker then they lowered it?

    Also, do you think the chances are high that the overnight lending rate stays at .50% for the next two years?


  2. Hi Mike,

    Thanks for your email and glad you have been enjoying my blog.

    In answer to your question, I would bet my bottom dollar that lenders will match future BoC rate rises to the penny.

    As for the chances that the BOC keeps its overnight rate at 0.50% for the next two years, that’s very hard to say with any confidence. For my two cents, based on current circumstances, I think it is likely that the overnight rate will be at or very near current levels in two year’s time, but my opinion is certainly subject to change!

    Best regards,

  3. It’s kind of a Catch 22 If you find a new house and buy it. You are paying for two moegtagrs if you sell your first one then dont have a place to go you could be stuck w/ your things in a storage place, and living in a motel. Best Wishes though.

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