See WOWA’s mortgage interest rate expectation/forecast in this table
|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.|
The most important interest rate in the Canadian economy is the overnight interest rate. The overnight interest is the annualized rate of interest charged in the overnight market. Participants in the overnight market may include Canadian banks, Canada’s asset managers, Canada’s brokers, Canadian insurance companies, retirement funds and any financial institution. Overnight lending in Canada is typically against the security of government of Canada securities (bonds and treasury bills).
For some Canadian financial institutions, overnight rates are the cost of capital as they fund themselves through the overnight lending market. For other institutions, overnight rates determine their opportunity cost of Capital. Thus overnight rates affect most lending and borrowing rates in Canada.
The yield of risk-free bonds in Canada is often composed of an expected compounded overnight rate plus a term premium. The expected compounded overnight rate is the cost of capital, and the term premium is the premium a borrower pays to insure themselves against an unexpected rise in the rate of interest.
As of June 28, 2023
Because of the importance of the overnight rate in the Canadian economy, the Bank of Canada (BoC) implements its monetary policy by setting a target for the overnight rate. In addition to the target for the overnight rate, BoC sets the deposit rate and the Bank Rate. The deposit rate is the rate of interest paid by the BoC to commercial banks, while the Bank Rate is the rate of interest charged by the BoC to commercial banks.
Currently (June 2023), the overnight and deposit rates are 4.75%, while the Bank Rate is 5%. The overnight rate cannot descend below the deposit rate as commercial banks can deposit their money with the BoC instead of lending it in the overnight market; they can even borrow in the overnight market and deposit it with BoC if the overnight rate is to fall below the deposit rate.
The overnight rate cannot ascend above the Bank Rate as chartered banks can borrow from the BoC instead of borrowing in the overnight market; they can even borrow from BoC and lend in the overnight market in the unlikely event that the overnight rate climbs above the Bank Rate.
BoC currently uses a floor system, which sets the target rate equal to the deposit rate. Suppose a liquidity shortage pushes the overnight rate higher than the target rate. In that case, BoC will intervene by lending into the overnight market and bringing the overnight rate back close to the target rate.
Bank of Canada has various roles to play in the economy and multiple targets to pursue. BoC’s highest priority is price stability, and its second highest priority is maximizing employment in the Canadian economy. The overnight target rate is the primary tool the BoC uses to achieve its inflation target.
For over two decades, the BoC has been targeting inflation such that the consumer price index (CPI), as defined and measured by Statistics Canada, increases by 2% per annum. If CPI rises slower than the 2% target, the BoC will lower its policy rate to lower interest rates throughout the economy. Lower interest rates facilitate borrowing and spending by Canadian consumers.
Higher levels of spending would increase the aggregate demand in the economy. More demand in the economy raises firms' pricing power and labour demand. Higher pricing power for firms translates into higher prices and inflation.
If CPI rises faster than the 2% target, the BoC would increase the overnight rate and thus increase various interest rates throughout the economy. Higher interest rates encourage saving and discourage borrowing. Higher savings and less borrowing result in a reduction of aggregate demand. Decreased demand for goods and services would reduce firm's pricing power and thus reduce inflation.
As of May 29, 2023
To see how much change in the policy rate is priced by the fixed-income markets, we consider the 1-month CDOR forward curve. CDOR stands for Canadian dollars offered rate. CDOR is the rate charged by Canadian Banks to companies on short-term loans. CDOR is a benchmark compiled by Refinitiv Benchmarks Services (UK) Limited. It is determined from a survey of major banks. Forward CDOR prices are supplied by Chatham Financial.
As we see, forecasting interest rates hinges on predicting the path of inflation. To form an opinion about inflation, we may start by looking at the composition of the basket of goods and services, which is used to measure Canada’s CPI. CPI reflects changes in the price of a basket of goods and services which is representative of consumption by Canadian households.
The CPI basket comprises 51.1% services and 48.9% goods. CPI basket composition includes 14.4% durable goods, 7.1% semidurable goods and 27.4% nondurable goods.
Looking at CPI categories, we see that it mainly comprises 29.8% shelter, 15.9% food, 16.9% transportation (gasoline alone accounts for 4.3%), Household operations 14.5%, and Recreation and Education 9.3%. These five major categories comprise 86.4% of the CPI basket. The remaining 13.6% is mainly composed of 4.6% for Alcohol, tobacco and cannabis, 4.6% for health and 4.3% for clothing.
|Recreation, education and reading||9.3%|
|Alcoholic beverages, tobacco products and recreational cannabis||4.6%|
|Health and personal care||4.6%|
|Clothing and footwear||4.3%|
When the pandemic started, central banks brought interest rates close to their lower bound of zero, and governments began to hand out money generously. At the same time, people were told to avoid contacting each other. So consumers allocated large amounts of money to purchase goods. This would have limited consequences before the pandemic as factories had a sizeable spare capacity worldwide. But supply chains became clogged during the pandemic, and production was disrupted.
Thus in 2021, goods inflation picked up and caused CPI inflation to overtake the central banks' target. Unfortunately, central banks called inflation transitory and continued stimulating demand until early 2022, when the war started in Europe. War in Europe caused a jump in hydrocarbon prices and accelerated inflation.
Consequently, in spring 2022 Bank of Canada and the Federal Reserve began to raise their policy rate to dampen inflation. The BoC’s rate rises immediately translate into rising the Prime Rate of Canada’s banks. As most lines of credit and HELOCs charge variable interest rates, changes to the BoC policy rate immediately increase interest payments by the borrowers. Also, interest and payment on adjustable-rate mortgages and variable-interest car loans immediately change after a change in the prime rate.
The effect of monetary policy famously has long and variable lags. The lag in the impact of monetary policy is, in large part, due to the nature of household debt. The amount of household debt in Canada has surpassed gross domestic product (GDP), but ¾ of household debt in Canada is mortgage debt. Most mortgages are either fixed or variable-rate mortgages. Fixed-rate mortgages are immune from the effect of changes in interest rates during their term, and variable-rate mortgage payments would not change unless their trigger rate is reached.
As rates rose and supply chains were declogging, inflation peaked in June 2022 at 8.1%. But in the meantime, all covid constraints were removed, and people who could not use many services during the pandemic tried to compensate by consuming more services. As goods inflation abated, service inflation accelerated, and service inflation was not transitory.
Yes, we have reason to believe that mortgage rates will decrease in 2024.
Over the second half of 2023 and 2024, we think higher interest rates would reduce household spending and thus bring down the aggregate demand in the Canadian economy. Consequently, firms would lose part of their pricing power. This development is also likely to increase the unemployment rate.
When BoC is confident that inflation is approaching its target, it can focus on achieving maximum employment. At that time, BoC will start cutting its policy rate in stages to change its currently restrictive monetary policy to neutral. A neutral policy rate is a policy interest rate which does not slow down the economy, while it also would not cause economic activity to accelerate. A lower policy rate would directly lower variable rates by the same amount, but fixed rates will decrease to a lesser extent.