|Date||BoC Rate||Prime Rate||5-Year Variable||1-Year Fixed||2-Year Fixed||3-Year Fixed||5-Year Fixed|
|This table is populated based on the information available on September 17, 2023. Use the most updated data to form your judgment for your financial decisions. In making these forecasts we have assumed the risk premium, and the term premium to stay constant and market expectation of the risk free rate to be correct.|
|By the end of||Likelihood of BoC policy rate at||is||Likelihood of BoC policy rate at||is|
|This table is populated based on the information available on September 16, 2023. Use the most updated information to form your judgment for your financial decisions.|
Canada’s annual inflation rose to 3.3% in July from 2.8% in June. The downward trend which brought the inflation down from 8.1% in June 2022 is intact and the policy rate is restrictive. The BoC has estimated the neutral policy rate (the overnight rate that facilitates stable economic activity without causing either an economic slowdown or acceleration) to be approximately 2.5%. This estimation consists of 2% inflation and 0.5% of real interest rate.
Currently, we have an overnight rate of 5% and an inflation rate of 3.3%. So the real overnight rate is 1.7% which is certainly restrictive. But different levels of governments have net borrowing of over $20 billion over the past half year (of available data). The government’s deficit spending has a stimulatory effect on the economy and slows the effect of interest rates on the rise of CPI. Government net borrowing from October 2022 to March 2023, just mentioned, is very small compared with the $43 billion of net borrowing between April 2020 and September 2020. However, a very low level of household spending at that time muted the effect of the government deficit.
Since March 2021, Canada’s inflation has been well above the BoC's target of 2%. Given that inflation has been over target for 2.5 years there is a danger that inflationary expectations might become unanchored. So the Bank of Canada likely needs to rise its policy rate one more time in 2023.
The current inflationary pressures in Canada began with increasing prices for goods, but this trend has reversed over the past year. Presently, the majority of inflationary pressure is coming from rising prices in the service sector. More specifically in July, annual goods inflation was 2.3% while the annual service inflation was 4.3%.
Assuming no new external economic shocks, we believe that monetary policy can sufficiently temper demand in the Canadian economy, hereby allowing the inflation rate to move closer to the BoC's target. This moderation in inflation is despite the Government's deficit spending, which is fueling inflation.
We expect that the full impact of the current restrictive policy rates will be felt throughout the Canadian economy in 2024, which should ultimately reduce demand for both goods and services. As a result, inflation should decrease and settle in the target range of 1%-3%.
This reduction in aggregate demand may lead to a significant decrease in the number of job vacancies. Furthermore, the high inflation experienced from 2021 to 2023 could strain household finances, potentially leading to higher labor force participation rates as families need to supplement their income. Higher participation rates, lower job vacancies and continued immigration would increase unemployment.
With inflation under control and a weaker job market, we anticipate that the Bank of Canada will gradually lower its policy rate toward the neutral level. We expect the policy rate to reach 4.75% by the end of 2024 and 4% by the end of 2025.
However, we anticipate that reverse globalization caused by tensions between Western countries on the one side and China, Russia, and some smaller states will be an inflationary force. Additionally, transitioning to more sustainable energy sources will require significant investments in energy infrastructure. A high level of investment would increase demand for capital which might increase the real interest rate. Due to the aforementioned factors and demographic changes, we expect the BoC rate will settle significantly above its pre-pandemic levels.
To see how the market thinks about the evolution of interest rates, we consider that depositing money with the BoC and buying treasuries are both riskless for a financial institution. So to maintain their liquidity, Canadian financial institutions would park their cash in either one, which offers a higher yield. As a result, the yield on a Canadian T bill should equal average of the expected BoC rate until T bill's maturity. This is called the expectation hypothesis.
The expectation hypothesis allows us to use yields on the money market instruments to derive market expectations for the BoC target policy rate. There are also many other interest rates in the market. Some of these rates allow us to infer the market's expectation of future interest rates more conveniently.
BAX contract prices are one of the rates which can conveniently suggest expectations for future changes to interest rates. BAX is a futures contract with the three-month reference Canadian Bankers Acceptance rate as the underlying price. The Investment Industry Regulatory Organisation of Canada (IIROC) publishes the reference for 1-month and 3-month Canadian Bankers’ Acceptance (BA) Rates based on actual transactions in the market. Prominent market participants (financial institutions) must report their trades to IIROC.
A BA is a loan made to a corporation but repaid by a commercial bank (from that corporation's line of credit with the bank). Because BAs are short-term and a commercial bank guarantees repayment, BA is a low-risk money market instrument.
BAX price implies the expectation of the market for the BA interest rate on the maturity date of the BAX contract. The difference between this rate and today’s BA rate implies the expected movement in the short-term interest rates on Canadian dollar debt.
Another way to conveniently calculate the market expectation of the likely changes in the BoC benchmark rate is using 1-month Canadian dollar offered rate (CDOR) forward contract rates as reported by Chatham Financial.
Predicting interest rates with certainty in Canada or any other economy is impossible. Yet we know the factors that affect interest rates, and by considering those factors, we can distinguish between more likely and less likely interest rate paths.
Between 1968 and 2001, interest rates were frequently greater than their current levels, but the Western economies, in general, and the Canadian economy, in particular, have changed considerably. Debt levels are much higher than during the 20th century, and tolerating high-interest rates is quite difficult in the 2020s.
Increasing debt levels can be deduced from rising income levels in combination with falling interest rates and largely stable debt service ratios.
Canadian Household income is growing much faster than the population. Since 1990, the population has grown by around 44% while household income has increased by 265%. Inflation over this period has been 93%. So household income has increased by 32% if we adjust for both inflation and population growth.
The total debt service ratio has increased from about 12% in the 1990s to approximately 14% in recent years. Note that interest rates for non-mortgage debt are often much higher than a mortgage. As a result, mortgage and non-mortgage debt service ratios are comparable, while mortgage debts are much larger than non-mortgage debts (about three-quarters of Canadian household debt is mortgage debt).
We can think of interest as a price for using money, yet interest differs from rent because money differs from real property. The intersection of the supply and demand curves for rental properties determines rents. Money is different from rental properties because the supply of money is unlimited.
Bank of Canada, Federal Reserve or any other central bank can buy an asset or make a loan by crediting the seller's or borrower's account. In this purchase or loan process, new money is created. More interestingly, when a commercial bank uses depositors’ money to make loans, it creates money. Because the depositors still have their money, while those who have received the loans also have the money and can spend it.
On the other hand, when a central bank sells an asset or receives a loan payment, money is destroyed. Similarly, when a commercial bank receives loan principal payments, money is destroyed (annihilated). This temporary nature of money allows policymakers to set its rent. In most countries, central banks are responsible for setting monetary policy.
In Canada, the Bank of Canada (BoC) has several responsibilities. The most important mandate of the Bank of Canada is achieving price stability. BoC has agreed with the Department of Finance to define price stability as having a 2% CPI inflation rate.
Canadian homes’ average price at a two-year low is over $600k. Thus a home buyer who has saved close to 20% for their down payment to reduce their risk and save on mortgage insurance premiums requires a mortgage of around $500k.
Currently, Canada’s interest rate environment is such that advertised mortgage rates range from 4.5% to over 7%. So if you are shopping for a mortgage, 5% is an attractive rate depending on the features of your mortgage.
WOWA’s mortgage interest calculator shows that conservatively buying an average house with a competitive mortgage rate would translate into a monthly mortgage payment of $2,900, initially including $2,100 in interest costs.
The median after-tax income for a Canadian family is $67K per year, around $5,600 per month. It is easy to see that the mortgage expense is the most significant expense of a Canadian family. The mortgage expense is much more for those living in the most expensive Canadian population centers of the Greater Toronto Area (GTA) and the Greater Vancouver Area (GVA).
|Factors that push interest rates higher||Factors that pull interest rates lower|
|High inflation||Low inflation|
|Low savings rate||High savings rate|
|Decreasing trade||Increasing trade|
|Risk of default||Loan security|
|Decrease in labour productivity||Increase in labour productivity|
|High employment||Low employment|
To understand how we can save on our mortgage costs, we should understand how mortgages work in Canada. A bank can use deposits it is holding to lend out a mortgage. The first problem with using depositor money for lending a mortgage is that those who have deposited their funds in a chequing account or a savings account might want their money back at any time.
In contrast, a mortgage borrower would repay his debt on a predetermined schedule over many years. So the bank would have to put aside some money to provide liquidity to its depositors.
Moreover, the bank might lose money on this loan if the borrower fails to make their scheduled payments and becomes delinquent. Thus such a mortgage would increase the amount of capital the bank requires. Still, because the loan is secured by real estate, it is pretty safe, and the added capital requirement it imposes on the bank is relatively small.
The three preceding paragraphs explained how a home equity line of credit (HELOC) works. HELOC interest rates are often slightly higher than the prime rate. Looking at variable mortgage interest rates, we see that most lenders offer rates well below the prime rates (and below HELOC rates). OSFI regulation imposes a HELOC limit of 65% of the property value. In comparison, conventional mortgages can be up to 80% of the property value, and high ratio (insured) mortgages can be up to 95% of the property value.
Because of their lower loan-to-value (LTV) ratio, HELOCs pose a lower risk to lenders than mortgages. We know an interest rate comprises a risk-free rate plus a risk premium. So why do HELOCs, despite their lower risk, have a higher rate than residential mortgages?
Mortgage rates are low because the National Housing Act created a legal framework to transform mortgages into safe and liquid assets. According to the National Housing Act (NHA), lenders can create a special legal entity (called a guarantor entity) and transfer their mortgages (after purchasing insurance for their conventional mortgages) into this entity which can issue what is called covered bonds.
Mortgages would serve as collateral for covered bonds. NHA also protects cover bond collateral from being affected by any bankruptcy proceedings. According to the NHA, the guarantor entity should be registered with the Canada Mortgage and Housing Corporation (CMHC). These bonds are called covered bonds because a pool of assets covers them. This means that a pool of assets (loans) is their collateral.
The legal framework of covered bonds allows Canadian financial institutions to transform their mortgage loans into liquid assets. This framework allows them to offer mortgages with interest rates materially lower than their prime lending rates. A bank has both liquidity and capital requirements. From the liquidity standpoint, an illiquid loan would require a bank to put aside some liquid (often low-yielding) assets to maintain its liquidity ratio. From a capital perspective, a liquid asset can be sold in bad times and prevent diluting shareholders by raising capital. So a lender is willing to advance liquid loans at a much lower margin than illiquid loans.
Covered bond programs reduce the cost of funding mortgages for Canadian lenders by transforming their mortgage assets into liquid assets. The other issue relating to mortgages is that many borrowers are unwilling to accept interest rate risk. At the same time, the cost of money for a financial institution often changes in line with the risk-free interest rate. So lenders are expected to offer fixed-rate mortgages and must manage their interest rate risk when offering fixed-rate mortgages.
The interest rate of savings accounts often changes with the risk-free interest rate. Therefore using deposits to make loans at a fixed interest rate brings interest rate risk to a bank. To mitigate this risk, the bank has to hedge its exposure to changes in interest rates.
One can use interest rate swap contracts to hedge their exposure to interest rates. An interest rate swap is a financial arrangement which enables a stream of variable-rate interest payments to be exchanged for a stream of fixed-rate interest payments.
Several types of swaps are available, including
A common form of interest rate swaps is called OIS. OIS stands for "Overnight Index Swap." It is a type of interest rate swap in which the two parties involved exchange the difference between an overnight interest rate index and a fixed interest rate.
The overnight interest rate index used in an OIS is typically the overnight interbank lending rate, such as the Federal Funds Rate in the United States, the Euro Overnight Index Average (EONIA) in the Eurozone, or the Sterling Overnight Index Average (SONIA) in the United Kingdom. However, the two parties involved in the swap agree on the fixed interest rate.
The purpose of an OIS is to manage interest rate risk by providing a way for market participants to protect themselves from fluctuations in overnight rates. Market participants with cash positions exposed to overnight rates can use OIS to hedge or mitigate that risk.
OIS is typically settled daily, with the swap value recalculated daily based on the current overnight index rate. This means that the swap value can change daily, depending on the movement of the overnight index rate.