You’re probably aware that the Bank of Canada has been making a series of cuts in its “policy” interest rate to stimulate the sluggish Canadian economy.
Expect those cuts to drive variable and short-term interest rates substantially lower in the next year for products like existing variable-rate mortgages. Just don’t count on big reductions in long-term rates from current levels, which affect products like new five-year fixed-rate mortgages.
“Even though the Bank of Canada is cutting, that doesn’t mean long-term interest rates are going to come down,” says Douglas Porter, chief economist at BMO Financial Group. “I wouldn’t count on big declines in long-term yields from here.”
To be sure, long-term rates have fallen a lot since October 2023. But while no one can predict future rates with certainty, there are reasons to think long-term rates may have bottomed and could end up a year from now not too far from current levels.
That should temper expectations about the degree to which falling rates will provide further boosts to the economy and housing market.
Variable versus long-term rates
Behind the divergence in variable versus long-term rate outlooks is the difference in how those rates are determined. The Bank of Canada policy rate strongly impacts the path of variable and short-term rates, but it has less influence over longer-term rates. Those are largely determined in the bond market and reflect additional factors.
The policy rate is also known as the target overnight rate. It is the target rate set by the Bank of Canada for financial institutions borrowing and lending between themselves for one day. It strongly influences variable lending rates such as the “prime” rate, which in turn is generally used as a base rate for variable-mortgage rates. It also strongly influences rates for deposit products like high-interest savings accounts and term deposits with short maturities (especially less than a year). The policy rate has much less influence on rates for financial products that don’t mature for a number of years, such as those for new or renewing five-year fixed rate mortgages, new or renewing five-year GICs, and bonds which mature in five or 10 years.
Bank of Canada policy rate
Since June, the Bank of Canada has been on a determined campaign to cut the policy rate so as to bolster the weak economy, while also keeping an eye on inflation to ensure it remains subdued.
The Bank of Canada signalled its aggressive intentions when it cut the policy rate in October by an unusually large 50 basis points (half a percentage point). That brought the policy rate down to 3.75 per cent, which came on the heels of three, 25-basis-point cuts since June.
The Bank of Canada is widely expected to keep those cuts coming in December and well into 2025. Overnight index swaps are pricing in further drops in the policy rate totalling close to 100 basis points in the next year, says Robert McLister, mortgage strategist and editor of MortgageLogic.news. Most economists at major banks are forecasting rate reductions of similar magnitude.
Cuts totalling 100 basis points would bring the policy rate down to 2.75 per cent.
Long-term rates follow their own path
Meanwhile, there are several reasons to expect that longer-term rates will follow a different path than the policy rate and likely end next year not far from where they are now.
Longer-term rates do incorporate expectations of future policy rates as a weighted average, but they also include an additional term premium, explains McLister. The term premium compensates bond investors for committing funds long-term and bearing the risk that interest rates may change over the term of the bond.
The Bank of Canada’s recent and future policy rate cuts have been widely expected for many months, so they are already built in to current long-term rates. “The bond market is anticipatory,” says McLister. “It has already priced in Bank of Canada cuts a long time ago.”
That anticipation helped bring down five-year Government of Canada bond yields to a low of around 2.7 per cent in September from a peak of 4.4 per cent in October 2023. Five-year government bond yields are a key benchmark for determining other long-term rates, especially five-year fixed mortgage rates.
But then in September bond markets started to get an inkling that future inflation might be more of a threat than previously thought.
As the Trump election bid gained popularity in the polls, bond markets started to worry about the eventual inflationary impact of his policies and related budget deficits on top of an already strong U.S. economy. Canadian bond markets foresaw a possible spillover effect on Canada because of our close economic ties.
“It’s definitely thrown the cat among the pigeons,” says Porter. “It is increasing uncertainty on the outlook.”
Longer-term interest rates started to edge up, especially in the U.S. but also to a lesser degree in Canada. Since mid-September, the five-year Government of Canada bond yield has risen more than 50 basis points to 3.21 per cent as of Wednesday. (The release of higher-than-expected Canadian inflation figures for October also contributed a little to rises in long-term bond yields last week.)
While no one can call a bottom with certainty (except in retrospect well after the fact), September could end up being the low point for long-term bond yields in the current easing cycle.
The current five-year Government of Canada bond yield of 3.21 per cent is still far below the current policy rate of 3.75 per cent, an inversion of the more common relationship. If the policy rate falls to 2.75 per cent in the next year while the five-year bond yield remains about the same, that would restore the usual pattern for a reasonably healthy economy, with long-term rates higher than the policy rate.
“In some ways this will just return the yield curve to a little bit more of a normal position,” says Porter.
In Porter’s view of rate movements in the next year, the current approximate level of long-term yields “is probably about where we’re going to settle in — maybe a little bit lower.”
Markets themselves incorporate similar expectations. Based on swap market forward rates early last week, markets are currently projecting that five-year Government of Canada bond yields fall by only a minuscule seven basis points in the next year, says McLister. “The market has a pretty good idea about what should happen based on knowable information,” he says.
While Canadian recession risks have been diminishing, they can’t be completely ruled out. If the recession threat looms large again, big, long-term rate declines will likely be back on the table, and so will even more aggressive policy rate cuts from the Bank of Canada.
Of course, there is also the possibility inflation will emerge as a bigger-than-expected menace and that both long-term rates and the policy rate will head much higher. There is enormous uncertainty about Trump’s policy specifics and what their eventual inflationary impact might be, so the possible “worst case” scenario for inflation could be severe.
