Bank of Canada cuts .50%: An Ounce of Prevention to Avert a World of Hurt
- Overnight target rate lowered 50bps to 3.00%
- Buoyant domestic demand, but worsening trade and credit conditions
For the second time in a row, the Bank of Canada has cut the overnight rate by 50bps, bringing the target rate to 3.00%. This is now the first time since 2001 – when Canada was last concerned about the fallout from a U.S. recession – that the Bank has seen fit to cut rates by a full percentage point in just six weeks time. While the latest statistics have underscored a resurgent strength in Canadian home construction, manufacturing, and international trade, the Bank is looking past these red herrings and has their sights set squarely on the formidable risks looming over the horizon. In their communiqué, the Bank noted that “buoyant growth in domestic demand…has been substantially offset by the fall in net exports.” Due to a “deeper and more protracted slowdown in the U.S. economy,” this drag from trade is expected to remain. And, in spite of financial conditions exacerbating these problems somewhat, the low level of unemployment and aggressive easing from the Bank to date highlights why many Canadians have remained fairly sheltered from the U.S. and financial-centred woes. But, the Bank now forecasts the Canadian economy will expand by 1.4% in 2008 (down from 1.8%) and 2.4% in 2009 (down from 2.8%). Moreover, with spare capacity expected to swell into 2009, the Bank sees inflation – now running below 1.5% by both the core and headline measures – not returning to its 2% target until 2010. On Thursday, the Bank will release their updated Monetary Policy Report. Based on this communiqué and recent statements, we expect the Bank to report dramatically lower expectations for U.S. and global growth compared with their January forecasts. Moreover, the Bank’s Business Outlook Survey (BOS) for Spring 2008 released last week showed firms’ declining expectations for future sales growth and investment spending, as well as a falling and below average share of firms reporting shortages of labour. The BOS also confirmed that the availability of credit remains as bad as it was last summer. Through its aggressive cuts and liquidity injections, the Bank hopes to ease these pressures. Lower rates will help shield the economy from externally-driven weaknesses, but the imbalances in the financial sector continue to impair shortterm borrowing. The Bank’s statement for “some further monetary stimulus” in the future may be a bit softer. However, the Bank’s forecast for Canadian economic growth in 2008 and 2009 still seems optimistic. Therefore, we continue to think that another 50bps cut at the next meeting on June 10th would be warranted given the balance of risks to the economy.
The Bank of Canada slashed its key interest rate by half a percentage point on Tuesday, as it warned of softer economic growth this year.
The cut reduces the bank’s overnight rate — what big banks charge each other for overnight loans — to three per cent. The overnight rate hasn’t been that low since December 2005.
It’s the second half-point cut in the last two months and brings the Bank of Canada’s total rate reduction to 1½ percentage points since December 2007. Bank of Canada Governor Mark Carney has slashed rates by a full percentage point since he took over the top job in February.
The big banks were slow to lower their prime lending rates by a corresponding amount. But by late afternoon, they had all announced half-point reductions in their prime rates to 4.75 per cent, effective Wednesday.
A cut in the prime rate leads to immediate savings for those who have variable rate mortgages, lines of credit and other floating interest rate loans.
Outlook reduced
The Bank of Canada has also reduced its outlook for economic growth, trimming its forecast to 1.4 per cent for this year. In January, the bank said it was looking for 2008 growth of 1.8 per cent.
The bank also trimmed its 2009 forecast by 4/10ths of a percentage point to 2.4 per cent. By 2010, growth is seen rising to 3.3 per cent.
“The bank is now projecting a deeper and more protracted slowdown in the U.S. economy,” the Bank of Canada said in a statement accompanying the rate announcement.
“This has direct consequences for the Canadian economic outlook, with declining exports projected to exert a significant drag on growth in 2008. In addition, tightening credit conditions and softening sentiment are expected to moderate business investment and consumer spending.”
The central bank will provide more details on its outlook for the economy on Thursday, when it releases its latest monetary policy report.
More rate cuts possible
The bank added that Canadian demand is projected to remain strong, supported by firm commodity prices, high employment levels and the effect of the Bank of Canada’s interest rate cuts.
The central bank left the door open for more rate cuts if they are needed to keep the economy moving.
BMO Capital Markets economist Douglas Porter said the latest round of cuts may be drawing to a close, given the bank’s aggressive actions.
“While we still look for another modest trim in rates at the next decision date in June, that may be the end of the line for rate cuts, especially if credit conditions begin to stabilize,” Porter said.
TD Bank senior economist Richard Kelly said the central bank’s forecast for economic growth in 2008 and 2009 “seems optimistic.”
“We continue to think that another [half-percentage point] cut at the next meeting on June 10 would be warranted given the balance of risks to the economy.”
Benjamin Tal updates brokers on interest rates and stresses the importance of staying current on rapidly changing events. Variable rate mortgages currently make up only about 20% of the Canadian market. We’ve seen a significant shift towards fixed in the past year or so, but now consumers are going back to variable because Prime is falling. I suspect this move to variable will continue for the next few months, but it will be short-lived. If the Bank of Canada rate is going to fall by another 50 bp, it will happen within the next few months. But that doesn’t mean the 5 year rate will also fall by that much. Remember, the bond market is already expecting this much of a cut in Prime and is discounting the 5 year rate based on that expectation. So while Prime may drop in the next few months, the 5 year rate will likely be relatively stable or slightly lower. “At some point, we’ll see a situation in which going variable may no longer be the best approach” Benjamin Tal. At some point—and it’s getting closer—we’ll see a situation in which going variable may no longer be the best approach. By cutting rates very aggressively now, the Bank of Canada is planting the seeds for inflation down the road. By the end of the year, it’s possible that we’ll see a significant correction in the bond market as the economy improves and inflation rises. If this happens, spreads will go back to normal and the 5 year rate will actually rise. Paying close attention to developments at this point is much more critical than at any time in recent history. A few years ago we could predict that short term rates were falling, so taking a variable rate mortgage was the right thing to do. Now, we know that inflation may start rising and therefore the 5 year rate will start rising at some point. But that can happen even earlier than we expect.
Clients need to be aware that while the 5 year rate is currently attractive, it can change quickly. Rates could rise by as much as 75-100 bp in 2009. It’s very difficult to predict. But clients need to understand this risk.
With interest rates changing rapidly and uncertainty in the market, mortgage consumers are wondering what to do. Should they go with a variable rate mortgage or lock into a fixed rate? Of course, mortgage brokers are well-positioned to offer such advice, but it’s essential that this advice be based on a thorough understanding of the current economic climate, as well as their clients’ tolerance for risk. If you have clients with a low tolerance for risk, they maybe better off opting for a 5 year fixed rate mortgage. As Benjamin Tal points out, there may be a brief window to benefit from variable rate mortgages before rates begin to rise again. But before clients make any decisions, they have to be fully aware of the risk and have the financial security and temperament to deal with it. When the economy is doing well, people are willing to take such risks. But as the economy slows and consumer confidence erodes, it adds an element of caution to the market.
If you have clients with a low tolerance for risk—for instance, a young couple with a big mortgage versus income—now may not be the time to recommend a variable rate. With the possibility that rates could change very rapidly, they may be better off opting for a 5 year fixed rate mortgage. During times of volatility, the mortgage broker’s role is more important than ever. Not only do you have to gauge your clients’ comfort with risk, you have to stay abreast of the latest economic information and analysis so you can provide responsible advice.
