Canada’s Overnight Rate Doesn’t Tell a Full Story

The Bank of Canada’s overnight target rate is the headline interest rate in Canada.  It sets the trend in a host of other key rates like mortgages, car loans, and commercial loans.

Currently, the overnight target stands at 1.00%—the lowest in history.  According to TD, however, it’s a misleading barometer.  A recent report from the bank suggests the effective overnight rate is closer to 2.48%.

According to TD, enormously wide credit spreads and other factors are actually making it “feel like the overnight rate is higher than it is.”  Put another way, TD says “higher levels of (lending) risk” have “pushed out spreads to levels much higher than ever previously witnessed. This has reduced the efficacy of Bank of Canada interest rate movements.”

As a result, the Bank of Canada has had to over-cut rates to compensate.

In the mortgage world spreads have improved but they’re still fat.  For example, TD says short-term borrowing spreads are averaging about 0.44% above normal.  This impacts all kinds of instruments, including bankers' acceptances—which help set the prices of variable-rate mortgages.

For long-term borrowing, spreads are even wider.  Using TD’s metrics, 5-year fixed mortgage premiums, for example, are still 1.42% higher than they should be.

Canada’s unusual spreads, among other things, have forced the bank of Canada to cut rates more than normal to inject adrenaline into our flailing economy.

Signs now point to further cuts on March 3:

• TD chief economics and rates strategist, Eric Lascelles, predicts the BoC will drop the overnight rate by yet another 1/2%.  (Bloomberg)
• “The deteriorating conditions in the labour market are
  consistent with the Bank of Canada’s outlook and should
  not change its decision to cut another 50 basis points in
  March.” (CIBC)
• “We're sticking to our call that they cut 50 basis points (1/2%) and leave their rate on hold for a long time." (Scotia Capital economist, Derek Holt)
• Fixed income traders “are pricing in a 100% chance of a 1/4% cut and a 30% chance of a 1/2% cut by March 3, 2009.” (CEP)

After March 3 it’s anyone’s guess where rates will go next. However, if the BoC does cut again, most analysts seem to think prime rate may drop and then stay put for a while. 

It remains to be seen whether the bond market (and fixed mortgage rates) will do the same.