This 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.
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.