Canadian mortgage borrowers waiting on the central bank may be disappointed by its latest move. The Bank of Canada (BoC) cut its overnight rate by 0.25 points to 2.75% on Tuesday. Many professionals applauded the decision, believing it would improve mortgage affordability. Unfortunately, that may not be the case, as the decision boosted inflation expectations and sent bond yields higher. This ultimately applies upward pressure on popular fixed-rate products, raising the floor of borrowing costs.
Bank of Canada Rate Cuts Influence Variable Rate Mortgages
Most people hear rate cuts and think that means cheaper mortgages, but that’s not always the case. The overnight rate only impacts short-term borrowing costs, such as variable-rate mortgages. Those reflected the 0.25-point cut immediately, with the lowest nationally advertised rate falling to 4.25% right after. However, variable-rate mortgages are historically a small part of the market and were only briefly popular during the low-rate pandemic frenzy.
Canadians traditionally prefer the stability of a 5-year fixed-rate mortgage. The cost isn’t based on the overnight rate, but bond yields—the Government of Canada (GoC) 5-year bond yield, to be exact. Credit is competitive, so lenders compete with this bond by offering investors a slightly higher yield.
Since the rate cut, the GoC 5-year bond yield has been climbing higher. The yield closed at 2.629% on Monday, and closed a little over a basis point higher after the Tuesday announcement. As of writing, the yield climbed to 2.673%, up 4.4 basis points.
That may not seem like a lot, but let’s assume it trickles down to a homebuyer of a $1 million property with 20% down. Rather than getting the post-rate cut discount they anticipated, they’ll pay $2k more over the term. It’s not exactly earth-shattering, but an average household will work an extra week to pay it off. Not the relief they anticipated, and it has only been a week. Each rate decision takes 18 to 24 months to impact a market fully. What gives?
Bank of Canada Repeats Pandemic-Era Mistake of Disregarding Data
Investor expectations influence bond yields, with inflation playing a big part. Investors are generally not in the business of losing money, so they factor inflation into their returns. As inflation expectations rise, so do bond yields to keep investors interested.
The BoC is a single-mandate central bank, and that mandate is inflation targeting. Its primary tool is interest rates to maintain its 2-point target, plus or minus a point of tolerance. When the rate falls too low, it slashes rates to stimulate borrowing and demand, hoping to drive inflation. When inflation is too high, it raises rates to slow demand and lower inflation. Simple enough, right?
When the BoC cut rates this week, it also did so while expecting a big jump in inflation. The GST/HST Tax Holiday was temporarily suppressing CPI, and concealing an increase. The central bank explained it expects the rate to rise as the effect of the Holiday is removed in February. As we noted earlier, there’s a good chance that CPI breaks the upper tolerance band. If this happens, the central bank may be forced to raise rates to throttle credit.
Typically a central bank wouldn’t cut at this point, as the country’s largest bank expected. The BoC decided to disregard its mandate and act on the emotional fear of the impact of the trade war tariffs. It disregarded its data-driven approach in favor of fear, which is something an amateur investor does, not a central bank.
The mistake echoes the ones made during the pandemic, leaving central banks with an inflation crisis. Rather than being data dependent, they felt the data was wrong and deferred to the gut instinct of policymakers. Most people still think inflation was a global crisis, but the BIS argues that central banks around the world just made the same mistakes, which is very different.
Rather than delivering cheaper mortgage credit, the central bank may have just raised the floor on borrowing costs. Good grief.