The BoC’s Bombshell

Wait a minute. Weren’t rates supposed to go up this year?

If it wasn’t embarrassing enough to be a rate forecaster before, it is now. Today’s surprise Bank of Canada rate cut proves for the umpteenth time that “experts'” long-term rate predictions are not only futile, but potentially costly.

Here are 5 things to know about the Bank of Canada’s policy move:

  • They really had to cut rates. Or did they?
    • Pundits are already debating whether the BoC jumped the gun today. The Bank said its rate reduction acts as “insurance” for the economy, given the shock of plunging oil prices.
    • But the BoC’s move comes despite its own expectations that core inflation (its key indicator) will settle at around 1.9-2.0%, both this quarter and this year—almost precisely on target. Moreover, we have a plunging loonie to consider (which could be inflationary) and lower rates (which will stoke a housing market that’s already near the boiling point in our two biggest cities).
  • There are likely more cuts to come
    • In his press conference today, Governor Poloz said the Bank has the ability to “take out more insurance,” meaning further rate cuts. Financial markets are now pricing in roughly a 40-50% chance of another cut this spring.
    • Since the dawn of modern monetary policy, however, the Bank of Canada has never lowered the overnight target rate just once. If history is a guide, we could see another ¼-point reduction in the next few meetings. Barring that we’ll at least have an extended stretch at 0.75%.
  • Lower funding costs will bring lower mortgage rates but…
    • There’s a big “but.” Lenders will pocket some of the improving spread, so we won’t see 5-year fixed mortgage rates match the drop in the 5-year government bond yield, at least not “beep for beep.”
    • While it is expected, banks have not yet announced any cuts to prime rate. It’s unlikely but there is precedent for them not to pass along a BoC rate cut. The spread between prime and the overnight rate was 175 bps in November 2008, but then grew to 200 bps in December 2008 where it has stayed ever since (until today).
    • We’re also waiting to see if the posted 5-year fixed rate drops. If so, it will become easier for people to qualify for a variable-rate mortgage (as well as 1- to 4-year fixed terms).
  • The odds of new mortgage rules in 2015 just went up
    • The Bank of Canada acknowledges that household imbalances (the debt-to-income ratio) will likely get worse, but it says the oil price shock could lead to income and employment losses that make the housing market even more imbalanced. Ottawa’s only answer may be to tighten mortgage restrictions further.
  • Don’t forget the penalties
    • If falling rates have you licking your chops about refinance opportunities, don’t forget that lenders have a little thing called “prepayment charges.” If you want to refinance to a lower rate and you’re in a big bank fixed-rate mortgage, the penalty and closing costs could easily offset most or all of your refi savings.

The next BoC rate meeting is March 4. If we get another rate cut then, it could make for a piping-hot spring housing market—possibly too hot for regulators’ liking.

  1. I was really surprised by the BOC decision to lower the overnight rate to .75. As I currently have a variable mortgage with TD, I would like to know how will this affect me. My current rate is prime minus .75, I was always under the assumption that if the BOC would raise the overnight rate my variable mortgage would increase by the same amount. Now that the overnight rate was lowered, should I assume that my variable rate will be lowered? Does a bank have to follow the rate from the BOC? If it is lowered do I need to contact the bank? Any input on this would be greatly appreciated.

    1. We can assume very little when it comes to rates. Unfortunately, the Globe and Mail reports that TD may not be lowering its prime rate. :(

      We’ll have to wait and see.

      And no, you don’t have to notify your lender if its prime rate drops. For existing variable-rate holders, the rate reduction is automatic in that case.

    2. How does this work? I thought the entire point of the variable vs fixed mortgage is that variable Wins out in the long run because when BOC rates go down (or up) your variable rate goes down (or up) as well. But if we can’t depend on the banks to move in lockstep with the BOC announcements, then the entire variable mortgage idea is flawed! When BOC rates go up, variable goes up….when BOC rates go down, variable does not move. How is this fair?

      1. It’s quite frightening really and sets a dangerous precedent for holders of variable mortgages if banks are allowed to set their own prime rate willy-nilly. Essentially then, a variable mortgage rate contract is no contract at all, as the FIs are free to do whatever they want with the rate.

        That being said, if this were brought to court, a judge may rule that variable contracts as they stand now are unconscionable since they provide absolutely no protection for the borrower in terms of rate.

      2. But if the banks drop the prime rate then it would not be fair to their greedy CEOs and CFOs as they would be deprived of the chance to making millions more in bonus and stock options.

  2. So all the red flags are out and about.
    Do we really need these low rates?
    Perhaps this is the election for federal government and they want to score big. I see trouble for Canadian real estate and possibly recession. My two cents!

    1. Always amazed at the number of people forecasting housing crashes and recession.

      “rates will go up and then you’ll see…”
      “rates are going down, now you’ll see….”

      Although I suppose if people keep saying it, eventually it will have to happen.

  3. So the self-righteous TD Bank thinks it knows whats best for Canadians and will protect them by making them pay more for debt and enriching their own shareholders further.

    This is the legacy of Ed Clark.

  4. I could be wrong but I would make a bet that the banks will all eventually drop to 2.75%. This is a BIG story, people were talking about it in the convenience store an hour ago when I as paying for gas. Mortgage interest rates in Canada are more tweeted about than kittens playing the piano and kittens and Kim Kardashian are the biggest things on the Web. Since the BOC Governor made the point of saying the rate reduction was important for the well being of the economy I think that there is simply too much reputational risk attached to the Big 6 Banks saying “to heck with the economy and the public, we need more gross profit”.

  5. The fact that the BoC can drop the overnight rate and banks can ‘choose’ wheter to lower their Prime rate really gets to me. Essentially then, a variable rate mortgage contract means that there is no mortgage contract on the part of the banks, since they can set their own rate at will.

    If they don’t lower their rates with this cut, I’ll bet they still hike them the first time the BoC rate goes up.

  6. I predicted on this website that the rates will not go up because they cannot go up (well, they may be able to go up, but veery slowwllly)
    Canadians are in debt to their eyeballs, but worse, the banks’ balance sheets are loaded with “safe” bonds that would be crushed with major increase in interest rates.
    Remember that fractional reserve banking is based on over leverage and modern financial engineering made it even worse with various derivatives.
    And the idea that rates have to go up because they are so close to 0 is clearly incorrect – just look at Switzerland where you pay the banks 0.75% to keep your money there.
    I fear (although is it really that bad?) that the next decade will be similar to Japan, with deflation, massive debt and very low interest rates. Just wait until China massive demographic crisis rears its ugly head…
    But anyways, I love my variable mortgage – I just hope that the banks will pass on the savings to the consumer.

  7. To be fair, I anticipate that there will be a brief period of “what-just -happened!” Followed by an even lesser moment of “wait-and -see” , after which an all-out mortgage war will ensue.

    WooHoo!!

  8. It’s going to be an interesting spring, wonder which lender will be the 1st out of the gate with a crushing 5yr fixed rate for the spring rush

  9. I think this rate cut will set the housing market on fire. Going to put a few offers this week on some detached properties. Everyone is going to be buying over the next few months until prices rise to a point where buying stabilizes.

    The Government can’t raise rates anymore. If they could, they would never have cut them. Hopefully, the government increases immigration numbers…need those renters.

  10. Great analysis as always, Rob. I do, however, take a little offense to the big banks being painted with a broad stroke around prepayment charges…lenders through the broker channel charge these as well.

    1. Thanks for the note Big Bank Guy. No doubt, a few non-bank lenders, credit unions, etc. also have onerous penalties. And brokers sell bank mortgages as well, so they too can be culpable. The key point is that *ALL* of the Big 6 have brutal posted-rate penalty calculations and the Big 6 dominate the mortgage market. So we’re speaking to the large majority here.

    2. All of the lenders that we deal with use the CONTRACT rate to calculate the IRD NOT the mysterious “posted” rate, that is only used to calculate penalties. There really is no way to defend this practice. It is smoke and mirrors and these lenders need to be more transparent. There is a woman taking CIBC to court for this very thing and I hope she wins.

  11. Yes I agree, it will be a wait and see whether the banks follow suit by lowering the variable. We are in interesting times.

  12. Hi Rob,

    Further to Ron Butler’s point, there is some reputational risk to the Banks if they don’t drop Prime. The last time they didn’t fully match a rate drop was during the financial crisis, when the fog of war obscured what they had done. This time should be different- they shouldn’t be able to get away with expanding margins during a time when their ROEs from domestic banking are already extremely high. Given the degree of government support for banking franchises (too big to fail credit subsidies, CDIC insurance premiums at artificially low levels, CMHC, barriers to entry to foreign competitors etc.) it represents a breach of faith with Canadians. However, unless the media steps into the fray, I think the big banks will get away with it. You’ve got the bully pulpit at the Globe- make them suffer a bit of reputational damage! If Rob Carrick steps in as well, it might even make a small difference….

    1. Hi Rob,

      Your blog is great, but I think you really punted in your globe article. You had an opportunity to do a little bit to put pressure on the Banks to drop prime (and help your many variable rate clients), but instead gave them cover.

      The list of excuses for the big banks not dropping prime is rhetorically impressive, but masks the reality-
      1. when markets are imperfect, you can get away with making economic profits, especially when regulatory authorities don’t hold companies to account
      2.if the capital market executive you interviewed was correct, and Ottawa really is complicit in the Banks not decreasing Prime, it should be getting much more media attention, and would be politically very harmful to the Conservatives (headline: Harper gives the Big Banks a $1 billion gift)
      3. If household indebtedness and credit issues are a concern, withholding a 25bp drop in rates from existing borrowers is harmful, not helpful. Tightening credit standards going forward is the path to addressing those issues.
      4.Modelling housing prices is difficult. No doubt a drop in rates would potentially put additional upward pressure on the housing market. However, although it might not be politically expedient, their are far more effective and direct ways of addressing housing prices than letting banks keep some additional margin on variable rate loans. Increasing the downpayment requirement is an obvious one. A less politically unpalatable move (which would directly address the issue of variable rate mortgages) would involve increasing the qualifying rate to 5 year posted plus a spread (1% perhaps).
      5. This is not an issue of mortgage margins, really. The marginal cost of funds for mortgages, which should set the price for variable rate mortgages, has unambiguously dropped by 25bp. The factors you described as bank excuses for not dropping prime (higher securitization costs, regulatory costs etc) were already in place prior to the BOC decision, and were already reflected in pricing. This is really about the infra-marginal cost of funds- ie core deposits. With a 25bp rate cut, the big Banks are making less off their core deposits. They’re trying to extract economic profits from mortgage borrowers to make up for the economic profits they’re no longer earning from much abused savers in 0% interest savings and chequing account. I know you’re aware that the banks transfer price their deposits and mortgage – Treasury charges the mortgage area for the use of fund, pays the deposit gathering function for the gathering of funds. In a rough and ready way:- The spread the mortgage area is making if the 25bp gets passed through on variable mortgage will be neutral. If it doesn’t get passed through, the mortgage area makes an extra 25bp. Either way, the deposit gathering function at the banks will see compression in their earnings. They’ll be paid less by Treasury for the funds they gather, but won’t be able to reduce their interest expense, as it’s already so close to 0. Although on a side note- I once went to a meeting with some bankers where they chortled about how deposit rates in Canada are already negative- people get paid 0% interest while having to pay a fee on their chequing accounts.

  13. Rob is dead on with those Big 6 penalty calculations, the last 7 major bank discharges that ran past our office averaged 4.20% in penalty cost. Bottom line: it is okay to have big penalties IF the client can see it up front. In many ways the 3.00% flat penalties that some monolines offer are a much more honest approach than hiding behind an IRD calculations that are incomprehensible.

  14. I’ll trade the Big 6 Banks not dropping their respective prime rates by 25bps this time around in exchange for no increase when the BoC increases the overnight rate by 50bps…toss in a few flying pigs while we’re at it.

  15. I have 3 mortgages coming up for renewal march 1 with firstline now cibc and they were hot to trot for an early renewal at just under 3% but I had to act fast. I didn’t as I thought they might go down a bit. I am thinking now is the time for the 5yr fixed for all three. 2 are variable one is a matrix. any opinion where these rates might go

  16. Lowering Interest Rate (LIR) well below the inflation rate is not at all a business strategy, rather it is a ventilator prepared for the dying policies to generate a false promise among the people who have no or limited vision.
    Because:
    -LIR eliminates the cash saving, as it gives low/no retur.
    – LIR increase overall debt on households as people try to get the advantage of lower interest rate by borrowing more and more money by considering low loan/mortgage payments.
    – More buyers are generated in the market, which increases the demand of high value products (specifically Automobiles, and real estate). This increases only the prices in real estate because of stagnant supply. Boom comes in real estate. Put the highest secured debt from the financial institutions on most of households.
    – Use all the savings; borrowing from friends and relatives is very common.
    – With the purchase of house, wants for furniture & equipments comes and max out of credit card, line of credit card debts.
    – Latter market makes an adjustment and real estate goes down. People accumulate high secured and very high unsecured debt.
    It is the time:
    – To stops paying unsecured debts,
    – Surrender secured vehicles,
    – Real estate left with negative or no equity.
    But initially they think that they can keep the house by meeting their mortgage obligations. However more sellers come in market and buyers are very few/rare. A drastic decrease in real estate starts. People surrender their houses to bank. Bank not able to get the full recovery of their money, shortfalls are shared by the isurer like CMHC in Canada.
    Conclusion:
    1. Lowering Interest rate ahead of time and without injecting the consequences of higher debt in the mind of debtors is not at all a healthy strategy. Rather it is the poorest approach.
    2. At this point of time keeping money in your pocket is the safest and most rewarding investment for your future. Seller Market will go and buyer market will come. It requires only a little patience.

    1. Hi RIC, Thanks for the post. Believe me, I’d love to see prime drop as much as you, but one can’t be a consumer advocate by ignoring reality. Banks’ first obligation is to economic stability. Their second obligation is to shareholders. Then come customers. When setting prime, there are more considerations today than ever before, as the story was intended to note. While some call those “excuses,” they all impact bank earnings or housing risk. Banks are under constant pressure from shareholders to continually hike earnings and dividends, so net margin is key. As you seem well aware, short-term/demand deposits are a vital source of funding for banks. With rates of 0% to 0.10%, there’s not much room to drop there. Meanwhile, a ¼ point drop forces them instantly to cut revenue on tens of billions in variable-rate product, assuming discounts remain static. Regardless of banks’ treasury function, this prime drop would put material pressure on overall earnings.

      Now, despite all that, banks would clearly violate their customers’ faith by not passing through the cut. So for that and other reasons, odds are still better than 50% that they will.

      1. Hope you’re right, Rob, but with each passing day, the odds of a rate drop decline. Unless they take a lot of heat soon, they’ll pocket the spread. I will reiterate that in a truly competitive market, the marginal cost of funds should determine product pricing. Something funny is going on when it doesn’t. That something funny appears to involve a compliant federal government. So far, that angle of the story hasn’t been given enough play.

        It’s a useless protest, but I for one will definitely be voting liberal in the next election. Perhaps I’m giving Trudeau too much credit, but I don’t think the liberals would allow the Banks to get away with this. At least I’m in Joe Oliver’s riding, so I can cast my vote against the guilty party….

        1. Hey RIC, The BoC may want prime to go down at the banks while the DoF wants banks to be prudent in rate discounting. The two are not mutually exclusive and those discussions may be happening as we speak. If only we could be flies on more walls…

      2. I am not an economist, so I may be missing a lot, but if the banks don’t decrease their prime, then BoC rate cut will be unsuccessful in its goal to help the economy. This pretty much guarantees further BoC decreases with the final effect of weakening the Canadian Dollar – some say that a weaker Canadian Dollar will help the economy, i just know that I will have to pay more for things.
        As “Ripped off consumer” said, that banks are just pocketing the difference. I guess with all the extra income they will be able to give larger bonuses to their executives, which will stimulate the economy with their caviar and Louis Vuiton (I hope I spelled it wrong!) purchases.
        There is no real competition in the banking industry, it is clearly a cartel. Although I do believe that you genuinely believe in what you said that the banks first obligation is economic stability, I think they are guided by the same values found in their colleagues from across the world – greed and hubris!
        Fractional reserve is one of the biggest scams in human history, creating a banking elite that makes money on having access to the source of money – BoC. They act like geniuses for making billions every year, but who wouldn’t when they can borrow at 1% or 0.75% then loaning it out at minimum 2%.

  17. Tell your customers to contact their branch manages , email the bank CEOs, let’s have some folks in the media set a “customer abuse countdown: 3 days and counting Canadian banks refuse to be fair” and put it on the front of their web pages.

    It is a legitimate fairness question because if the BOC had RAISED the rate there would have been no TDCT CEO saying: “there are many factor effecting our rate decisions; we are leaving the rate alone” he would have raised the rate in a heartbeat. Have your clients contact their banks with one message: Be Fair.

    1. I actually just sent an email to CIBC stating my displeasure in their procrastination and/or possible refusal to adjust to the BOC rate cut.

      Surprisingly I received a reply within minutes, stating they can understand my concern and they are reviewing their prime rate in light of the decision by the BOC and they will let clients know if any changes will be made.

      Hmmmm. Our branch manager asks us about our mortgage renewal every time we see her, confident she will secure our renewal from our broker. It will be easy to say, “Not so fast, remember when…”.

    2. Although it may not do much, I asked on Twitter Stephen Harper, Justin Trudeau, Thomas Mulcair and BoC why the banks have not matched the drop in prime.
      They can ignore me as one person, but many more ask the same question, maybe it will get bigger.

  18. At the end of the day the market will swing with the direction taken by the country’s two biggest banks and that’s RBC and TD. TD said no, RBC has yet to make a decision, and if both of them say no then I highly doubt any other bank would sacrifice their margins when the others are not. Personally I don’t believe they will pass the 25 bps to their customers this time because it’s only the first cut. There may be more cuts this year and if there are more cuts then I think they will be under a lot more pressure to pass some savings and they will pass some savings. For now they will use the market volatility card to justify not providing the savings which they have used a few years ago.

  19. Let’s review this week’s activity, shall we.

    The Canadian 5-year bond closed today at 0.79%, having smashed through the formerly “unthinkable” 1.0% barrier with ease, and the BoC lowered the overnight rate to 2.75%.

    Yet ,the Canadian banking oligopoly (dare I say cartel?) does absolutely nothing in response. Is this the hallmark of a competitive financial free-market on display?

    And what ever happened to the prospect of garnering market share with lower rates and all of the profitable cross-selling opportunities entailed?

    This is starting to stink.

  20. Definitely a surprise move and definitely good news for the Canadian housing market which has been having a decade of prosperity. Certainly good news for home buyers and sellers across Canada.

  21. Very disappointing to hear that the big banks will not reduce their rates. Is it fair to say that if the BOC had increased it’s overnight rates the banks would have done the same? When I chose a variable mortgage I did it with the knowledge that if the BOC rate would go up I would pay more and if it went down I would pay less. I guess I was misinformed by my TD mortgage advisor and I will definitely bring it up when my mortage comes up for renewal.

  22. There seems to be a lot of confusion around why the BOC dropped their rates and why banks weren’t so quick to follow. Unfortunately, once again, Canada is just one very small part of a much larger global macroeconomic game. Didn’t it seem odd that a rate cut came so sudden and with what appeared to be little support for why they did it?

    The Big Banks weren’t surprised by the move – after all, they talk every week with the BOC. This was a coordinated event.

    When you have large American institutions / investors shorting the Canadian banks (perhaps banking on a housing collapse), and the negative price pressures of a falling CAD, the Canadian banks need support. My guess is that the BOC were seeing downward foreign forces on Canadian Banks, and stepped in to help them out by increasing their spreads. Quite brilliant really. I just hope that this play doesn’t have to last to long, because while a clever short term move, it does have a negative impact on Canada’s long term.

        1. Not all public statements.

          “Our decision regarding our prime rate is impacted by factors beyond just the Bank of Canada’s overnight rate. Not only do we operate in a competitive environment, but our prime rate is influenced by the broader economic environment..” – Mohammed Nakhooda, TD

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