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  • Writer's pictureJose Gustavo Salcedo

Opinion: Bank of Canada Rate Cuts Won’t Necessarily Reduce Mortgage Costs

Opinion: Bank of Canada Rate Cuts Won’t Necessarily Reduce Mortgage Costs

There’s been a lot of buzz about how the Bank of Canada’s recent interest rate cuts will boost the Canadian housing market. While it’s true that these rate cuts are expected to be gradual, there’s an important aspect that’s often overlooked: for many homeowners, lower rates won’t actually mean lower borrowing costs.


Variable vs. Fixed-Rate Mortgages


Variable-rate mortgages are directly affected by rate cuts and will see an immediate drop in borrowing costs. However, the 2024 CMHC Mortgage Consumer Survey shows that only 23% of Canadian mortgages are variable-rate. In contrast, 69% are fixed-rate, with the majority of these being five-year terms, though three-year terms are becoming more popular.


Bond Yields and Fixed-Rate Mortgages


Fixed-rate mortgages are influenced by bond yields rather than directly by the Bank of Canada’s policy rate. The assumption that rate cuts will reduce bond yields—and thus fixed mortgage rates—is flawed. Significant drops in bond yields are unlikely because it would continue the current situation where long-term rates are lower than short-term ones, which is abnormal. Normally, longer-term rates are higher due to increased risk over time.


Projecting Future Rates


If we fast-forward to a time when the Bank of Canada has completed its rate-cutting process, we would expect the policy rate to align with a “neutral” rate, estimated between 2.25-3.25%. Assuming a midpoint of 2.75%, the Bank would still need to cut rates by about 200 basis points. Historical data from 1996-2005 shows the average spread between the Bank rate and bond yields was 84 basis points for three-year bonds and 112 basis points for five-year bonds. Applying these spreads to a 2.75% rate suggests future three- and five-year bond yields of 3.64% and 3.87%, respectively.


Current Bond Yields


As of last week, the three-year bond rate was 3.80% and the five-year bond rate was 3.43%. While three-year rates could slightly decrease by 16 basis points, five-year rates would actually need to increase by 44 basis points to reach their expected normal level. This means that longer-term mortgage rates could potentially rise, contrary to what many experts are predicting.


Conclusion


A return to normal monetary conditions is unlikely to lower mortgage costs significantly. In fact, the cost of longer-term mortgages might even go up. Current bond yields are relatively low compared to both the current bank rate and the projected neutral rate. Bond markets, which are forward-looking, likely anticipate a successful return to target inflation and thus might not respond dramatically to rate cuts.


While rate cuts might indirectly boost the housing market by reducing costs for auto loans, lines of credit, and other consumer borrowings, and by providing greater economic stability, the direct impact on most mortgage costs will be minimal.


Bottom line: Don’t expect Bank of Canada rate cuts to bring significant relief to mortgage costs. Instead, homeowners with fixed-rate mortgages may see little to no change, and some might even face higher rates in the future.


Adapted by Jose Gustavo



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