Predicting Bank of Canada Rate Policy

The Canadian real estate market strongly depends on the Bank of Canada’s benchmark rate (“BoC rate”). This rate represents the minimum rate charged by the Bank of Canada for one day loans to major financial institutions. All lending in Canada is based on the BoC rate as lenders, who take risks by lending out their money, want a premium above the BoC rate for the additional chance of default. When the BoC raises rates, it means the BoC believes that the Canadian economy is doing well and firing on all cylinders. It also results in increased costs of borrowing, as interest rates for lending rise, affecting all sectors of the economy and especially the highly leveraged real estate market.

All mortgage rates are based on the BoC rate. Variable mortgage rates follow Bank Prime rates which follow the BoC benchmark rate. Fixed mortgage rates are based on the government bond yield curves and predictions towards future rates. According to ratehub, as of March 29, 2019 the fixed and variable rates for the main big five banks in Canada are very close, especially for RBC and Scotia.

Rates are for new mortgage, amortization term of 25 years and LTV of 85%

Reversing a previous trend, fixed rates are now even lower than variable rates for some of the big banks. This is because fixed rates are correlated to the 5-year government bond yield, which is currently at 1.43% (March 27, 2019). This is lower than the current BoC benchmark rate at 1.75% and signifies that the bond market believes that the BoC rate will not remain at 1.75% but may decrease over the coming years. This is an amazing finding. Why?

The current benchmark rate of 1.75% already represents a lower than normal rate. For five decades from 1958 to 2008, the BoC rate has never gone under 2%. Even recently from 2000 to 2008, it reached 4% before the Great Financial Crisis. The bond market is predicting future rate decreases, which would only happen in the case of a weakening economy or recession. While this does not bode well for Canada’s economy, it does mean highly leveraged homeowners can breathe a sigh of relief and count on low interest payments.

It is difficult to predict the effect of this trend on real estate market. On one hand, a lower interest rate means more people can afford more expensive houses. On the other hand, a slowing economy may mean lost jobs and lower income, which reduces the ability and willingness of people to make large financial purchases such as a house. These effects may or may not balance themselves out. But if Canada’s economy slows as part of a global recession, then the effects may be drastic. Given the influence of especially Asian buyers on the Canadian real estate market, its health may ultimately depend on Asian economies and the flow of funds from them into the Canadian real estate market.

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