Canada Should Trail U.S. Rates

Canadian-US-mortgage-ratesThis week, the U.S. central bank put the world on notice that rate hikes are coming, possibly as early as spring.

While we shouldn’t hold our breath on that, it does raise one important question: How will the Bank of Canada respond if the U.S. does boost interest rates?

The answer is far from certain, but one thing can be said with confidence: the BoC will not respond in knee-jerk fashion.

Here’s why, and what it means for mortgage holders:

  • Disinflationary Oil: Canadian economic performance, not Federal Reserve rate policy, will ultimately determine the BoC’s next rate move. Yes, the Fed and our rates are tightly intertwined, but projected inflation rules BoC decision-making. If Canadian inflation reacts to plummeting oil prices like it did in the U.S. (where inflation just posted its biggest drop in six years), there will be no rush to hike rates here. Canada’s latest core inflation reading (which came in well below forecasts at 2.1%) was as positive as rate doves could hope for.
Oil Prices (NYMEX, WTI)
  • Insufficient Exports: Falling oil prices stimulate developed economies. Unfortunately for oil-leveraged Canada, the lost capital investment and deflationary effects of sub-$60 oil will likely offset the positive impact of higher exports—according to analysts. The BoC seems to agree. “…The lower profile for oil and certain other commodity prices will weigh on the Canadian economy,” it said on December 3. The Bank projects up to a 1/3 percentage point hit to GDP because of it—leaving Canada with a GDP near 2%. If the U.S. economy keeps motoring on, 2% Canadian GDP would be the least—relative to U.S. GDP—since 1996. Other things equal, that should again hold inflation and Canadian rate hikes at bay.
  • In Hock Consumers: Everyone (especially the BoC) knows that Canadians are worrisomely indebted. That makes significant rate hikes all the more risky. Higher rates create higher debt-servicing costs, something that as many as 1 in 5 homeowners cannot comfortably afford, based on surveys. With housing overvalued by up to 30%, and low rates being a major reason why, overzealous BoC action could easily upset the housing apple cart.
  • Wait and See: Before lifting rates on this side of the border, it’s quite possible that the BoC will wait and see how rate hikes affect our southern neighbour. “What we’re being set up for here is a historic policy lag behind the Federal Reserve,” Scotia Economics told its clients last week. It’s not surprising then that bond yields in Canada are slowly diverging from (i.e., lagging) those in the U.S. (See the 10-year yield chart below.) Furthermore, many forget that in the 1990s America’s key policy rate was 250 basis points higher than ours.


  • Market Expectations: Financial traders bet billions on what the BoC will do and when. Those professionals are not pricing in a rate hike in 2015, and that’s telling given all the Fed hike talk of late. Market expectations, based on overnight index swap (OIS) prices in this case, tend to be somewhat more reliable than economist forecasts.

The takeaway here is that the low-rate era is far from dead. The U.S. could easily hike rates one percentage point or more without motivating the BoC to follow.

At this point, most financially stable borrowers shouldn’t even think about locking in their variable mortgages. The five-year bond yield would likely have to break its one-year high to signal rate hikes in Canada…and that buys everyone some time.


Chart sources: Oil: NASDAQ; 10-year yield spreads: Bloomberg.com

  1. Overall good article except in one area.** Canadian Consumer overindebtedness (more later on residential real estate “overvaluation, another work of fiction}–CCO*, don’t believe all you hear/read.Main challenge to middle class is overtaxation. on average more than 42 % of gross wages paid in taxes (more than housing, food & clothing combined for that “average” Canadian Family}. Should federal gov’t & provincial (forget civic for any savings they seem to be first order of spenders), say work hard to redcue taxes by say 7 %. Call thge tax savings a debt retiremnt bonus & encourage families to reduce debt with the tax rebate & then after 5 or 6 years the 7 % (annually) should get a lot of debt reduced and paid off. Last, in 20002 UK has a royal commissiontasked with studying the contention that the brithish consuymer was overindebted. The commission came back with a report stateing that they were “agnostic” on the issue. They felt that the exercise (consumer overindebted} was both unknown & unknowable. Too many variables to state emphatically.
    my comment: when was last time BOC & econmists really looked @ provincial & federal finances?

    1. “Mortgae trends says”..1) Higher rates create higher debt-servicing costs, something that as many as 1 in 5 homeowners cannot comfortably afford, based on surveys.
      ..”based on surveys”?.Check the real life analyses. Only small minority (within tolerance) of mortgagors @ risk with inevitable
      rate increases. Mortgage/R.E. Fables should be diligently tested
      for accuracy & truth.

      2) .. “With housing overvalued by up to 30 %”
      David Says..Housing is very much local. That 30 % is simply not supportable overall . I am surprised a mortgage brokers website/magazine would keep repeating this mantra which is not true & never has been. Canada is over-regulated & over-taxed ,those are the two main problems.
      Accepting the above (housing overvaluation), by industry participants, permits, I believe, Government(s) to even do more damage. There is a role for regulation, od course, but 6 years after American housing meltdown (which had nothing to do with Canadian R.E.), it would seem to be time to move on. ..
      Canadian Family net worth & finances stronger than any level of government’s finances. This is some context to Gov’t’s being “all knowing” when Gov’t debt/taxation is out-of-control.
      another example. Ontarion electicity rate double in about 8 years.
      tracking inflation would indicate that in about 26 years the electricity costs should double.

      1. Hey David,

        On your first point, the story referenced homeowner’s ability to “comfortably afford” significant rate hikes. The concept of “at risk” homeowners, while relevant, requires some definition and is a slightly different conversation. The point here was simply that rate hikes would impact today’s leveraged consumers more than in the past. That makes it less likely that the BoC will aggressively run rates higher.

        On the second point, it’s important to remember the context. It goes without saying that when Bank of Canada states that Canadian housing could be up to 30% overvalued, it is not referring to housing in Moncton, NB or Windsor, ON. When commentators, economists or the Bank of Canada refer to “housing,” it is commonly in a national context because the health of the macro economy is the question. From a rate setting standpoint, it’s vital to assess Canada-wide housing in aggregate. Otherwise, the BoC couldn’t evaluate its impact on nationwide inflation, which is the BoC’s mandate.

        On a side note, while real estate is predominately driven by both local factors, we can’t forget that it’s also impacted by the national economy, national level of interest rates, global economies, etc. Moreover, local markets can indeed have national influences. If Toronto’s housing market crashed for example (and I’m definitely not predicting this), it would have a very real effect on many other local real estate markets far from Toronto.

  2. Rob,

    You forgot one driver: declining demand for Canadian currency. Folks switching from CDN$ to something else could force the BofC into action.

    This is happening in other countries currently.

    1. Hi Tomas, The BoC’s mandate is inflation control. Poloz considers manipulating currency a “bad idea,” something that “would give us larger fluctuations in unemployment, output and inflation.” The currency level enters its decision making only to the extent that it threatens to push inflation out of the 1-3% target range, or during a currency crisis. At all other times, the BoC is content to let the loonie float with market forces—which are largely dictated by commodity prices.

      More perspective from the BoC: http://www.bankofcanada.ca/2014/09/float-of-the-loonie/

      1. Talking about discipline and being disciplined are two very different things.

        BofC can only hold a low rate while there’s a steady stream of buyers for Cdn gov’t debt.

        Can you see a circumstance in which a typical debt buyer chooses lower rate Cdn debt versus higher rate US debt?

        It’s competition for cash flow that drives rate right?

  3. Tomas

    Due respect but you’ve got it backwards, mate. Bond prices affect currency prices more than currency prices affect bond prices.

    To your second point there are ample buyers for undisputed AAA bonds with less inflation risk than the U.S. That’s why our 5 year is 1.44% while the yanks are at 1.73%.

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