Bank of Canada Makes Emergency Rate Cut, Stress Test Changes Delayed, Due to COVID-19

The Bank of Canada (BoC) has announced an emergency rate cut to its trend-setting Overnight Lending Rate, as the Canadian government moves to reduce the economic repercussions of the COVID-19 pandemic. 

In an unscheduled announcement on March 13, the central bank revealed it was cutting its interest rate to 0.75% – the second 50-basis-point cut this month. BoC Governor Stephen Poloz stated it was a “proactive measure”, as the Canadian economy grapples with the impact of the virus, along with the social distancing measures now put in place to stop its spread. As well, recently plummeting oil prices contributed to the decision to slash the cost of borrowing.

“It is clear that the spread of the coronavirus is having serious consequences for Canadian families, and for Canada’s economy,” the BoC stated in a release. “In addition, lower prices for oil, even since our last scheduled rate decision on March 4, will weigh heavily on the economy, particularly in energy intensive regions.”

The BoC plans to release its next rate announcement on April 15, along with a full update on its monetary policy plans.

An Out-of-the-Ordinary Move

It is highly unusual for the BoC to announce a change to interest rates outside of its typical six-week schedule; the last time it did so was during the 2009 financial crisis. Combined with the interest rate cut made on March 4^th, its Overnight Lending Rate now sits at 0.75%. The announcement was made in tandem with comments from federal Finance Minister Bill Morneau and the Superintendent of Financial Institutions Jeremy Rudin, that financial stimulus will soon be revealed to support Canadians in the coming weeks.

The move was mirrored by the U.S. Federal Reserve, which moved on March 15 to slash its interest rate range to 0%, also in its second rate cut this month.

Why is the Bank of Canada Cutting Interest Rates?

One of the main responsibilities of the BoC is to keep the Canadian dollar stable, along with the rate of inflation. Among its most powerful tools to do this is its ability to tweak the cost of borrowing via its Overnight Lending Rate, which consumer lenders use as a benchmark for the cost of lending to each other, thereby keeping funds liquid.

They also use the BoC’s rate when setting the cost of their own variable lending rates – as a result, whenever the BoC makes a change, the “Big Five” – think Bank of Montreal, Scotiabank, TD, CIBC, RBC – typically follow suit with discounts or increases to the cost of their variable mortgage and line of credit products.

By keeping the cost of borrowing low for consumer lenders in an economic downturn, the BoC can help avoid a credit crunch; liquid funds among banks mean they can continue to lend to consumers, which in turn keeps household spending and consumption moving.

What Will Be the Impact on Mortgage Borrowers?

Because the BoC’s rate directly impacts the cost of variable lending, those with variable-rate mortgages will see either their monthly payments drop in tandem, or more of their payment going toward their principal debt and less towards interest. 

While the BoC’s movements do not directly affect the fixed cost of borrowing, rate reductions will ultimately be felt across that market as well; that’s because in times of economic uncertainty, investor demand for “safe haven” investments such as government bonds, rises. That in turn causes bond yields to drop – they have an inverse relationship with investor demand, as the maturity payoff tends to be lower for low-risk investments. 

Banks, meanwhile, take their cues from bond yields for their fixed borrowing products, meaning further discounts will be made available to those looking for a new fixed-rate mortgage or those looking to renew or refinance their existing one. It should be noted, though, that as fixed mortgages are “locked in”, anyone mid-term will not be able to take advantage of today’s lower rate environment, unless they break their mortgage early. 

As of today, the Government of Canada five-year bond yield sits at 0.68% – a multi-year low.

New Stress Test Changes to be Delayed

Along with the rate cut and promise of stimulus, it was also announced Friday that recently promised changes to the mortgage stress test, which were scheduled to go into effect on April 6, will be put on ice until further notice.

On February 18, the Department of Finance stated it would be tweaking the qualification criteria used in the test for insured mortgage borrowers, switching from the Bank of Canada’s five-year benchmark rate (which is in turn set by an average of the Big Bank posted five-year fixed rates) to the weekly five-year median insured mortgage rate used in mortgage applications, plus 2%.

The change would have materially reduced the threshold these borrowers need to qualify at in order to obtain home financing, as the rates offered by lenders for insured mortgages are typically much lower than the posted rates at the big banks; for example, the current BoC rate sits at 5.19%, while many lenders offer insured mortgage rates today below 3%. In fact, if the new median rate was made available now, it would sit at 4.89%. 

According to calculations from Ratehub.ca, a borrower with a household income of $100,000 getting a mortgage rate of 2.89% and tested at the new rate would qualify for a home valued at $526,632, $15,000 more than the $511,424 they’d receive under the current rate.

While the change was only for mortgage borrowers putting less than 20% down on their home purchase, it was widely expected that the same tweak would be made for the uninsured mortgage market as well – however, the Office of the Superintended of Financial Institutions (OSFI) has also announced it will be suspending the consultations it was planning to undertake to do so, meaning easier stress test requirements won’t be seen for the foreseeable future for either type of borrower.