Good News for Variable-Rate Mortgage Borrowers: Governor Poloz Shifts the Bank of Canada Into Neutral (For Now)

Dave Larock in Interest Rate UpdateMortgages and Finances

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All eyes were on Bank of Canada (BoC) Governor Poloz last Wednesday when he spoke at the Board of Trade in St. John’s, Newfoundland.

These were his first public comments since the BoC began to raise its overnight rate in July. Market watchers have been debating whether the Bank would now pause, after reversing the two 0.25% rate cuts that it had made in 2015 in response to the oil-price shock, or continue to raise rates to mitigate against the risk of rising inflationary pressures over the medium term.

The answer to that key question has important implications for both fixed and variable mortgage rates.

If the BoC continues to raise its overnight rate, lender prime rates will move higher in lock step. And since variable-rate mortgages are priced on lender prime rates, additional policy-rate increases by the Bank will immediately translate into higher borrowing costs for variable-rate borrowers.

Fixed-rate mortgages are priced on Government of Canada (GoC) bond yields, and while those yields do not automatically move when the BoC raises its policy rate, they often respond to changes in the Bank’s outlook. This is especially true for longer-term GoC bonds because their extended duration makes them highly sensitive to even subtle changes in the BoC’s views on inflation and growth.

The title of Governor Poloz’s latest speech is “Data Dependence: Economic Progress Report” and that further piqued my interest because in several of my recent blog posts I have made the case that our key economic data should give the BoC pause before it hikes its policy rate further. (In those posts I explain why the surging Loonie, low inflation and sluggish wage growth all support a near term wait-and-see approach by the BoC.)

Here are the highlights from Governor Poloz’s speech last week:

  • Governor Poloz emphasized that while the BoC’s “economic models are indispensable” they are only “a starting point”. He explained that the Bank also uses “soft data”, such as confidence surveys and myriad conversations with businesses on both “Bay Street and Main Street”, as overlays on its models.
  • He cited the oil-price shock in 2015 as an example of where the Bank combined its economic modeling with soft data to determine the correct policy path. The BoC’s economic models estimated that the plunge in oil prices would drain “approximately $60 billion in export revenue” from our economy, and that estimate prompted the first 0.25% cut. But the Bank then received anecdotal feedback about companies being flooded with resumes, contracts being cancelled and businesses forgoing planned investment spending, and that feedback prompted the second 0.25% cut.
  • Governor Poloz said that the BoC has since estimated that if it had not dropped its policy rate by 0.50% in 2015, “the economy would be roughly 2% smaller today, a difference of about $50 billion dollars, and there would be about 120,000 fewer jobs”.
  • Today, the Bank believes that “the economy’s adjustment to lower oil prices [is now] essentially complete”, not because our energy sector has fully recovered but because that sector’s remaining weakness is being offset “by greater strength in other areas”. Importantly for future policy considerations, the BoC believes that this improvement is due in large part to the cheaper Loonie.
  • Governor Poloz acknowledged our economy’s impressive second-quarter GDP growth, which came in at 4.5%, but he said that the Bank expects this momentum to slow over the second half of this year. That view was quickly bolstered last Friday when our initial GDP data for July were released and showed no new GDP growth over that month.
  • Governor Poloz acknowledged that our inflation rate has been “dominated by downside risks” over the past five years but he noted that there is “a long lag between economic activity and inflation”. He said that while the Bank now expects inflation to move gradually higher, the timing of that move may be delayed by the recent rise in the value of the Loonie.
  • Governor Poloz acknowledged that “the appropriate path for interest rates … is very difficult to know” in the current context because of “several important unknowns around the inflation outlook”, which he also described as “unusual”. These include “the legacy of the global financial crisis, the protracted period of slow economic growth, and extremely low interest rates”. In such a period of “heightened uncertainty”, he said that the Bank will become even more “data dependent”.
  • Governor Poloz emphasized four key focus areas for the Bank moving forward:
    1. Monitoring the evolution of our economic capacity – The Bank will closely watch how our economy’s actual economic output compares to its maximum potential output. Doing this is complicated by the fact that our maximum potential output is a moving target.
    2. Understanding the interaction between technological advances and inflation – The Bank is trying to assess the evolving impact that technology is having on inflation. If it is temporary, the Bank “would want to see through it” (which is central bank speak for ‘ignore it’), but if its impact is more structural than cyclical, the Bank will have to account for it in its economic models.
    3. Understanding why wages aren’t rising faster - Current wage growth “has been slower than expected in an economy that is approaching full capacity”. Governor Poloz attributed some of this trend to our economy’s shift from higher-paying energy-sector jobs to lower-paying jobs in other sectors but he also acknowledged that the BoC does not yet fully understand all of the factors that may be at play here.
    4. Monitoring how the impact of rate increases is magnified by our elevated household debt levels – Governor Poloz said that “interest-rate increases may have more of an impact on the economy, and therefore inflation, than they did in the past” because today’s household debt levels are so high. In addition, he said that the Bank can’t fully quantify the impact that the recent mortgage rule changes have had on our housing markets because they haven’t yet had time to run their course.

Governor Poloz closed by saying that “the economic progress that we have seen tells us that the moves we took to ease policy in 2015 were the right thing to do. At a minimum, that additional stimulus is no longer needed, but there is no predetermined path for interest rates from here”. And in case that didn’t make the BoC’s shift-to-neutral position loud and clear, he then said that the Bank “could still be surprised in either direction” and emphasized that it would “feel [its] way cautiously” forward while keeping its inflationary target “front and centre”.         

Five-year GoC bond yields fell seven basis points last week, closing at 1.75% on Friday. Five-year fixed-rate mortgages are still available at rates as low as 2.79% for high-ratio buyers, and at rates as low as 2.89% for low-ratio buyers, depending on the size of their down payment and the purchase price of the property. Meanwhile, borrowers who are looking to refinance can find five-year fixed rates in the 3.24% to 3.34% range.

Five-year variable-rate mortgage discounts remain largely unchanged and are still available at rates as low as prime minus 0.90% (2.30% today) for high-ratio buyers, and at rates as low as prime minus 0.75% (2.45% today) for low-ratio buyers, again depending on the size of their down payment and the purchase price of the property. Borrowers who are looking to refinance should be able to find five-year variable rates in the prime minus 0.50% to 0.40% range, which works out to between 2.70% and 2.80% using today’s prime rate of 3.20%.

The Bottom Line: It is now clear that the BoC’s recent rate increases were specifically intended to reverse the two rate cuts that it made in response to the oil-price shock in 2015 and were not intended to be the first rounds of a broader BoC monetary-policy tightening cycle. Going forward, Governor Poloz described the Bank’s approach as “particularly data dependent” and committed to keeping its inflationary targets “front and centre”. With that in mind, I expect that our mortgage rates will stay at or near their current levels at least long enough to allow time for more of the BoC’s “unknowns” to become known.

David Larock is an independent mortgage broker and industry insider specializing in helping clients purchase, refinance or renew their mortgages. David's posts appear weekly on this blog, Move Smartly, and on his own blog: Email Dave

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