Out With the Old Bias, In With the New Bias? (Monday Interest Rate Update)

Dave Larock in Monday Interest Rate Update, Mortgages and Finance, Home Buying, Toronto Real Estate News

Editor's Note: Dave's Monday Morning Interest Rate Update appears
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When the Bank of Canada (BoC) meets this Wednesday I think there is a good
chance that it will remove the interest-rate tightening bias that it has kept in
place, in one form or another, for more than a year now.

Simply put, the cost of maintaining that tightening bias now clearly
outweighs the cost of removing it.

When BoC Governor Mark Carney first started warning Canadians that our
borrowing rates would rise more quickly than most were expecting, he cited
rising household debt levels, and more specifically, increased borrowing against
residential real estate, as the primary threats to our domestic economy. He
acknowledged this most recently in a speech last week, saying that the BoC’s
rate-tightening bias was designed “to complement efforts of the federal
government and OSFI to achieve a constructive evolution of household debt.”

Over the past several months however, our rate of household debt growth has
fallen precipitously and Governor Carney said in the same speech that he now
“expects residential investment to decline further from historically high

If it’s true that the BoC and the federal government now believe that the
combined threat of housing and credit bubbles is off the boil, their next big
worry must surely be our faltering economic growth. And if increased consumer
spending isn’t regarded as a healthy form of economic stimulus because it will
re-accelerate our household borrowing rates, then businesses are going to have
to take up the charge. In the words of Governor Carney, “the challenge for
Canada is to rotate the sources of growth toward net exports and business

So why hasn’t this happened? After all, this isn’t the first time that
Governor Carney has implored businesses to use either their cash-rich balance
sheets or the BoC’s ultra-low borrowing rates to invest in productivity
enhancements and expansion.

For starters, businesses are nervous. Especially exporters with U.S.
customers who are grappling with the challenges inherent in our lofty Loonie.
There are many factors that have pushed the Loonie higher against the Greenback
such as our stronger government balance sheets, our less onerous future health
care and pension liabilities, not to mention our lower unemployment and
inflation rates, which still imply that GDP growth should be higher in Canada
than in the U.S. going forward (despite current short-term trends). But the
BoC’s rate-tightening bias has also contributed to the Loonie’s rise and that’s
where the main incentive to remove it lies.

Somewhat surprisingly, Governor Carney actually disagrees with the view that
a strong Loonie hurts our economy. Instead he argues that it provides a net
benefit through higher commodity prices, and that the free flow of jobs and
trade between provinces allows our economy to adjust on the fly when the Loonie
appreciates. Most economists disagree with him, however, and it has been
speculated that new BoC Governor Stephen Poloz’s background as the former head
of Export Development Canada (EDC) makes it a good bet that he will favour a
weaker currency in an effort to stimulate export growth. When sales are up, goes
the other side of the argument, businesses will start investing and they won’t
need the BoC Governor imploring them to do it.

But if the BoC removes its interest-rate tightening bias, how can it ensure
that households will not ramp up borrowing again? To address this risk, federal
finance minister Jim Flaherty has now effectively replaced the BoC’s
rate-tightening bias with a mortgage-credit tightening bias.

Last week Mr. Flaherty warned that he was “looking at” other forms of CMHC
insurance, which have helped keep residential mortgage rates low, like the bulk
portfolio insurance it offers on mortgages where the home owners have more than
20% equity in their property. I can’t help but wonder if this was done as a
precursor to the BoC’s removal of its interest-rate tightening bias - a warning
of sorts to dissuade us from queuing back up to the borrowing punch bowl as soon
as the BoC changes tack.

After four rounds of changes to the CMHC policies for high-ratio mortgage
insurance and more recently to OSFI’s lending rules for all mortgages, when Mr.
Flaherty warns about tightening credit conditions no one doubts that he’ll pull
the trigger.

It’s understandable that Mr. Flaherty would be nervous about a shift in
monetary policy threatening the soft landing that he recently claimed has been
achieved for our housing markets. But the federal government and the BoC do not
have the luxury of time. While Canada has fared remarkably well during the long
and drawn out Great Recession, our economic momentum has slowed of late and
there is real urgency in getting businesses to spend again.

If the BoC removes its tightening bias, there should be downward pressure on
the Loonie and this will give our beleaguered exporters a much needed shot in
the arm at what feels like a critical inflection point, one way or the other,
for our economy.

We’ll find out on Wednesday.

Government of Canada five-year bond yields were 2 basis points higher for the
week, closing at 1.38% on Friday. While some lenders have raised their five-year
fixed rates, I still have attractive options available at well below 3%. That
said, if bond yields continue to rise this could change in a hurry, so borrowers
who are currently in the market for a fixed rate are still well advised to lock
in sooner rather than later. 

Five-year variable-rate mortgages are offered in the prime minus 0.45% range
(which works out to 2.55% using today’s prime rate).

The Bottom Line: For the reasons outlined above, I think the BoC’s
rate-tightening bias has outlived its usefulness. As such, I think there is a
very good chance that the Bank will soften its interest-rate language as part of
this Wednesday’s policy announcement. Stay tuned.

David Larock is an independent mortgage planner and industry insider specializing in helping clients purchase, refinance or renew their mortgages. David's posts appear weekly on this blog (movesmartly.com) and on his own blog integratedmortgageplanners.com/blog). Email Dave

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