The Bank of Canada May Test the Courage of Variable-Rate Borrowers Sooner Than Expected

The Bank of Canada (BoC) took a surprisingly hawkish turn last week and Government of Canada (GoC) bond yields surged higher in response.

Last Monday, Senior Deputy Governor Carolyn Wilkins gave a speech in Winnipeg and offered the following insights into the Bank’s evolving policy-rate view:

• The Deputy Governor reiterated the BoC’s belief that “the adjustment to lower oil prices is now largely behind us”. That statement is significant because the Bank’s last two policy-rate cuts, in 2015, were made in direct response to collapsing oil prices. If the BoC believes that our economy has completed the necessary adjustments to that oil-price shock, those emergency rate cuts may now be unwound.
• The Bank wouldn’t raise its policy rate if it thought that the rest of the economy still needed emergency-level stimulus, and to that end, Deputy Governor Wilkens observed that there are “encouraging signs that growth is broadening across regions and sectors”. Our economy has grown by an average of 3.5% over the last three quarters and Ms. Wilkens noted that “70 per cent of industries have been expanding and the labour market continues to improve”, although, as I noted last week, more jobs have not led to more pay for the average Canadian worker thus far.
• Deputy Governor Wilkins reiterated that the Bank’s main policy-rate objective is maintaining its target of “a 2 per cent inflation rate”, even at the expense of promoting growth. All of our inflation gauges remain well below the BoC’s target, but that statement gives added importance to this Friday’s release of the Consumer Price Index (CPI) inflation data.
• Like every good economist, Deputy Governor Wilkens hedged a little by noting that “slack in our economy is still translating into below-target inflation” and that “risks to the outlook remain”. That said, she noted that “monetary policy must anticipate the road ahead” and her underlying message was that policy-rate hikes may now be approaching more quickly than previously expected.

The market’s reaction to the Deputy Governor’s speech was somewhat dramatic as both Government of Canada (GoC) bond yields and the Loonie increased sharply. The BoC has repeatedly cited its concern about the “competitiveness challenges” of the Loonie’s strength relative to a basket of other currencies, and its more hawkish policy-rate language has now exacerbated the impact of that challenge.

Against that backdrop, BoC Governor Poloz gave an interview the following day, and observers wondered if he would walk back the Bank’s more hawkish language after watching the market’s reaction the day before. He didn’t seem fazed, however, and reiterated that our economy is “gathering momentum” and that “the interest rate cuts we did two years ago have done their job, and that’s important to us”.

As the prospect of the first BoC rate hike in seven years approaches, variable-rate mortgage borrowers will have their courage tested in the following ways:

• If GoC bond yields continue to rise, fixed mortgage rates will move higher in response. That means that variable-rate borrowers will see their conversion rates increase, making the cost of their emergency parachutes more expensive.
• If and when the BoC does finally raise its policy rate, it won’t take long for the gap between current five-year variable rates and the five-year fixed rates that were available to borrowers at the time they started their current term to disappear. The gap between fixed and variable has been narrow for years, and a policy-rate increase of 0.50% would pretty much wipe it out for most variable-rate borrowers, thereby eliminating their original margin of safety and marking an important psychological milestone.
• Many first-time buyers have parents who lived through 18%+ interest rates in the 1980s and they’ll be reminded of that when variable rates finally start to rise.

I would offer variable-rate borrowers the following observations to keep things in perspective as the pressure to convert to higher fixed rates ratchets up:

• The BoC has repeatedly said that it will maintain a cautious approach when tightening monetary policy, that record-high debt levels mean that the amount of tightening required will be less than what was required in previous cycles, and on a related note, that our economy’s neutral rate will be significantly lower than it was prior to the financial crisis of 2008. (As a reminder, the neutral rate is the rate “that is neither stimulative nor contractionary when an economy is operating at full capacity”). Those points should serve as a reminder that this is not the 1980s and this is not your parents’ mortgage-rate environment.
• Further to that point, inflation has been stubbornly low for years now, and that has largely been a result of long-term trends that aren’t changing anytime soon, such as aging populations, elevated levels of public and private debt and increased levels of automation, to name just a few.
• As per the point made above, rate rises will push the Loonie higher and exacerbate the “competitiveness challenges” of the Loonie’s value relative to a basket of other currencies. The more the BoC raises, the stronger this headwind will become.
• It has been eight years since the last U.S. recession and there are early signs that economic activity south of the border is slowing. If the U.S. economy enters a recession, the U.S. Federal Reserve may quickly unwind its recent policy-rate increases and the BoC would have to respond in kind to prevent the Loonie from surging higher. While the BoC has the luxury of lagging the Fed when it raises rates, it would have much less flexibility if the Fed cuts them instead.
• Rate rises will have a dampening effect on economic activity in real-estate related sectors (that already appear to be in a slowing phase), and while that might be the least of the BoC’s concerns if it helps slow the rise in our household borrowing levels, it will also slow momentum in the sector of the economy that has been our main engine of growth since the Great Recession. A sharp slowdown in real-estate-related sectors could quickly trigger our next recession, especially if a surging Loonie slows our export sector’s momentum at the same time.

Five-year GoC bond yields rose eighteen basis points last week, closing at 1.14% on Friday. Five-year fixed-rate mortgages are available at rates as low as 2.29% for high-ratio buyers, and at rates as low as 2.34% for low-ratio buyers, depending on the size of their down payment and the purchase price of the property. Meanwhile, borrowers who are looking to refinance should be able to find five-year fixed rates in the 2.59% to 2.69% range.

Five-year variable-rate mortgages are available at rates as low as prime minus 0.80% (1.90% today) for high-ratio buyers, and at rates as low as prime minus 0.70% (2.00% today) for low-ratio buyers, again depending on the size of their down payment and the purchase price of the property. Borrowers who are looking to refinance should be able to find five-year variable rates around the prime minus 0.40% to 0.45% range, which works out to between 2.20% and 2.25% using today’s prime rate of 2.70%.

The Bottom Line: The BoC struck a more hawkish tone last week and both the Loonie and GoC bond yields surged higher in response. As the prospect of the Bank’s first policy-rate increase in seven years appears on the horizon, variable-rate mortgage borrowers will have their courage tested, but for the reasons outlined above, that doesn’t mean that it’s time for them to panic.