Are Canadian Variable Mortgage Rates Headed Lower?

Our economic data haven’t been very encouraging of late and that has caused many of the borrowers I speak with on a daily basis to speculate about whether our variable mortgage rates may be headed lower. While this is a reasonable view to hold under normal circumstances, in today’s post I’ll explain why I don’t think it will happen any time soon.

To briefly set the stage, our GDP growth rate hovers between 0% and 1%, our economy isn’t producing enough jobs to keep pace with the natural rise in our working-age population, and our average income growth is barely keeping pace with overall inflation growth, benign as it is.

Against this backdrop, the Bank of Canada (BoC) would normally be expected to drop its policy rate in an effort to stimulate economic growth, and lenders would quickly pass on that additional saving by lowering their prime rates, which our variable-rate mortgages are priced on. But today we live in anything but normal times, and if you choose a variable-rate mortgage with the expectation of future rate cuts, I think you will be disappointed.

To expand on this view, let’s look at the two key events that must both take place if variable mortgage rates are to fall from today’s levels.

Step one: The BoC must drop its overnight rate.

Here are three reasons why I think it won’t:

1. The Bank has repeatedly said that our high household debt levels are the single biggest threat to the stability of our financial system. Cutting the overnight rate could exacerbate this risk. It would also remind Canadians of the quote “your actions speak so loud that we can’t hear what you say”, rendering future BoC warnings about household debt levels impotent. It’s a credibility thing.
2. The BoC has repeatedly said that any sustainable Canadian recovery must be led by business investment in productivity enhancements and capacity expansion. But today’s ultra-low interest rates have encouraged business to engage in share buy backs and acquisitions of competitors instead (because with today’s rates, it’s easier to buy your competition than to outperform them in the open market). Odds are that additional policy-rate drops would just encourage more of these inefficient and non-productive behaviours.
3. If the BoC were to cut its overnight rate from 0.50% to 0.25%, it could spook the market. The last time we saw 0.25% we were in the midst of the Great Recession and central banks around the world were slashing their policy rates to emergency levels at a time when fear about the stability of the global financial system was palpable. If businesses interpreted further cuts as acts of desperation, instead of providing stimulus, the cuts could backfire and end up reducing investment further.

In summary, additional BoC rate cuts are far more likely to exacerbate high household debt levels than to start encouraging businesses to invest more productively, and they may even spook markets. For those reasons, I don’t think the Bank is in any hurry to ease its monetary policy further, despite rising pressure to “do something” in the face of our deteriorating economic data.

Unless, of course, another central bank forces the BoC’s hand.

If the U.S. Federal Reserve were to drop its policy rate first, the BoC would need to either match the Fed’s rate cut or risk a sharp appreciation of the Loonie which would then threaten our still nascent export recovery. While the recent strength in the U.S. economic data might lead you to believe that a Fed rate cut is unlikely, history suggests otherwise. Prominent economist David Rosenberg recently observed that whenever the Fed has paused for more than six months after hiking its policy rate, as it has now done, its next rate move has always been a cut.

So now let’s assume that the Fed drops and the BoC matches. If that were to happen, Canadian variable-rate borrowers would still only be halfway toward lower rates.

Step Two: If the BoC drops its overnight rate, Canadian lenders need to pass on the additional discount to variable-rate borrowers.

Here are three reasons why I think they won’t:

1. When the BoC dropped its policy rate twice in 2015, by 0.25% each time, lenders only passed on cuts of 0.15% to variable-rate borrowers. (In fact, when the BoC cut last July, TD immediately announced that it would only drop its variable rates by 0.10% in an attempt to lead the market to an even smaller discount. It was only when other lenders dropped by 0.15% that TD matched that level.) The 2015 partial rate drops were a reminder that a BoC rate cut does not automatically translate into an equivalent variable-rate mortgage cut.
2. Normally, the BoC would be expected to put pressure on lenders to share its additional policy-rate discount with borrowers to ensure that its stimulus is passed on to the broader economy. But the BoC might well be exerting pressure the other way around this time, encouraging lenders to hold rates steady to avoid further increasing consumer debt and allowing lenders to pocket the extra spread as a reward for their prudence.
3. Of course, lenders would feel their own pressure to keep that additional rate saving on their books. That’s because variable-rate mortgages are almost always less profitable than fixed-rate mortgages, so if today’s household debt levels were to give lenders cover to bring their variable-rate spreads closer to their fixed-rate equivalents, I think they would jump at the chance.

Five-year Government of Canada bond yields fell one basis point last week, closing at 0.60% on Friday. Five-year fixed-rate mortgages are available in the 2.39% to 2.49% range, depending on the terms and conditions that are important to you, and five-year fixed-rate pre-approvals are offered at about 2.54%.

Five-year variable-rate mortgages are available in the prime minus 0.40% to prime minus 0.50% range, which translates into rates of 2.20% to 2.30% using today’s prime rate of 2.70%.

The Bottom Line: When our economic data soften, it normally leads to speculation that the BoC will drop its overnight rate, and in so doing, trigger a rate cut for variable-rate borrowers. But these are not normal times, and if you are considering a variable-rate mortgage today because you believe that there are rate cuts on the horizon, I would advise you to think twice. To be clear, I don’t think either our fixed or variable rates will rise materially in the foreseeable future. I just wouldn’t be choosing a variable rate on the bet that it’s headed lower any time soon.