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.

Canadian Mortgage Trends

 January 21, 2015   Robert McLister   42