Many argue against variable-rate mortgages given that rates “can’t drop much more.” But while it’s true that rates are near the bottom, there’s still a question of “where’s the bottom?”
The Bank of Canada’s floor for the overnight rate—the rate that drives prime rate—was previously established at 0.25%. It sat at that all-time low from April 2009 to June 2010.
At the time, Governor Mark Carney said:
“…We thought long and hard about where the effective lower bound was in Canada. Our judgment was—and it’s been validated, I think—that we could bring rates down to 25 basis points…and that markets would continue to function well.”
“Because there are transaction costs associated with operating [shorter-term money] markets…if the net yield is close enough to zero, then those markets will cease to function.”
In its April 2009 Monetary Policy Report the Bank added:
“In principle, the Bank could lower the policy rate to zero. However, that would eliminate the incentive for lenders and borrowers to transact in markets, especially in the repo market. Therefore, to preserve the effective functioning of markets in a low interest rate environment, the Bank is setting an effective lower bound (ELB) of 25 basis points for the overnight rate…”
Much has transpired since then, however. Louise Egan, a spokesperson for the Bank of Canada, says that since 2009 “we’ve seen in some other countries that it’s possible for nominal interest rates to be negative due to the costs of holding currency, and so the thinking has advanced among central banks on the subject.”
In today’s world, if inflation risked falling below the Bank of Canada’s 1-3% target range, a 0% overnight rate wouldn’t be off the table completely, just unlikely. In fact, even negative rates are possible, as we’ve seen in many other countries. But according to Desjardins, “outside of an unlikely scenario where the Fed adopted such type of policy, there is little chance that the BoC would go this far.” Moreover, the Bank would likely use other monetary policy levers before it took extreme measures like cutting the overnight rate to zero or below.
“You know, for us, forward guidance is usually the next sort of place [we’d consider]…,” said Governor Stephen Poloz last month. “…What you’re doing in forward guidance is…you’re trying to influence not today’s interest rate, but how interest rates are perceived through the yield curve, so that you’re affecting the profile of expectations for interest rates…That leads to…more financial stimulus than you otherwise would have with a normally shaped yield curve.”
“The Bank, of course, did use some forward guidance in the past,” Poloz added. “We said that when we would normally use it would be in unusual times or at the zero lower bound…”
That is consistent with its prior usage, notes Bank of America rate strategist Ruslan Bikbov. “We saw back in 2009…the next step after the quarter-of-a-basispoint (overnight rate) was forward guidance,” he says. “They haven’t actually discussed the possibility of negative rates, or even zero.”
The Bank of Canada, as noted in this paper, can “reduce long-term interest rates by issuing forward guidance…” Doing so “lowers market expectations of the future path of the policy rate.” In turn, the 5-year government yield would likely drop, as would longer-term fixed mortgage rates.
If forward guidance doesn’t work, the BoC could try its hand at quantitative easing (QE). That’s where the Bank buys government securities in order to keep prices up and rates down. The fear, however, is that QE could remove bonds from trading, negatively impacting liquidity in Canada’s small-ish government bond market.
If QE did come to pass, it could potentially mark the long-term bottom in rates. That’s partly because its stimulative effect would likely result in higher inflation expectations, alleviating the need to ease policy further.
Given the BoC’s comfort with a 25-bps key lending rate, the 1 in 4 mortgagors with variable rates may see prime rate drop no more than another 10-25 basis points from here, depending on banks’ generosity following another 25-bps BoC reduction. And another cut is still very much on the table with Canada heading towards a “low-magnitude recession,” and with overnight index swap traders betting on a rate cut by January.
The wildcard is the Federal Reserve. It could hike rates later this year—some speculate as early as September. Of course, Canada’s rate market could always keep diverging from the U.S., but given the long-term correlation of U.S. and Canadian rates, a Fed hike could easily keep Canadian rates level, if not boost them somewhat.
“If the Fed moves in September, you will probably see higher rates in Canada, including five-year bonds,” said Bikbov. “By December, we may see another cut from the Bank of Canada and potentially another hike from the Fed. I think the net-net effect will probably be a five-year rate (in Canada) that’s a little bit lower.”
At the very least, we have lots more rate volatility and uncertainty to look forward to. So if you’re a mortgagor watching all of this, hold on for the ride. Rates in the second half of 2015 could be one surprise after another.