In the second surprise of the morning, Bank of Canada (BoC) announced that the interest rates will be cut from 1% to 0.75%. That 25 basis points may not seem like much, but it goes to show that all is not well with the Canadian economy. The slump in the oil and energy sector has seen numerous job cuts announced with more to come. One report has suggested that the Canadian tar sands might see upto $60B in capex cuts over the coming weeks and months. Not just the oil sector, retail stores have been announcing bankruptcy and/or simply just pulling out of the Canadian market.
A move to cut rates from the BoC was expected, but not until later this year. There have been plenty of indications – both from the bond market and the forex market to suggest that the Canadian interest rates would be cut. Some banks were expecting that announcement to come later in the year. Following is the statement from BoC.
“The Bank of Canada today announced that it is lowering its target for the overnight rate by one-quarter of one percentage point to 3/4 per cent. The Bank Rate is correspondingly 1 per cent and the deposit rate is 1/2 per cent. This decision is in response to the recent sharp drop in oil prices, which will be negative for growth and underlying inflation in Canada.
Inflation has remained close to the 2 per cent target in recent quarters. Core inflation has been temporarily boosted by sector-specific factors and the pass-through effects of the lower Canadian dollar, which are offsetting disinflationary pressures from slack in the economy and competition in the retail sector. Total CPI inflation is starting to reflect the fall in oil prices.
Oil’s sharp decline in the past six months is expected to boost global economic growth, especially in the United States, while widening the divergences among economies. Persistent headwinds from deleveraging and lingering uncertainty will influence the extent to which some oil-importing countries benefit from lower prices. The Bank’s base-case projection assumes oil prices around US$60 per barrel. Prices are currently lower but our belief is that prices over the medium term are likely to be higher.
The oil price shock is occurring against a backdrop of solid and more broadly-based growth in Canada in recent quarters. Outside the energy sector, we are beginning to see the anticipated sequence of increased foreign demand, stronger exports, improved business confidence and investment, and employment growth. However, there is considerable uncertainty about the speed with which this sequence will evolve and how it will be affected by the drop in oil prices. Business investment in the energy-producing sector will decline. Canada’s weaker terms of trade will have an adverse impact on incomes and wealth, reducing domestic demand growth.
Although there is considerable uncertainty around the outlook, the Bank is projecting real GDP growth will slow to about 1 1/2 per cent and the output gap to widen in the first half of 2015. The negative impact of lower oil prices will gradually be mitigated by a stronger U.S. economy, a weaker Canadian dollar, and the Bank’s monetary policy response. The Bank expects Canada’s economy to gradually strengthen in the second half of this year, with real GDP growth averaging 2.1 per cent in 2015 and 2.4 per cent in 2016. The economy is expected to return to full capacity around the end of 2016, a little later than was expected in October.
Weaker oil prices will pull down the inflation profile. Total CPI inflation is projected to be temporarily below the inflation-control range during 2015, moving back up to target the following year. Underlying inflation will ease in the near term but then return gradually to 2 per cent over the projection horizon.
The oil price shock increases both downside risks to the inflation profile and financial stability risks. The Bank’s policy action is intended to provide insurance against these risks, support the sectoral adjustment needed to strengthen investment and growth, and bring the Canadian economy back to full capacity and inflation to target within the projection horizon.”
How Does This Impact Us?
What does this all mean? We are staring disinflation and deflation in the face and this move continues and makes it even easier access to cheap money. Investors can expect the gravy train to continue for a while and continue investing in high income producing assets such as REITs, pipelines, utilities etc without the risk of interest rate rise. In addition, the Canadian dollar (loonie) is taking a dive after the announcement. This also fits in well with my strategy of continued US$ strength, and how my investments in the past are placed to take advantage of the trend.
On a personal finance front, mortgage rates will see some decline if you have a variable mortgage rate. Wooohooooo!! This is what I am most excited about 🙂 My wife and I decided to go with variable rates last summer when we bought our house as I suspected that the bank would probably not be able to raise rates this year. At the time, some people thought I was crazy to even think of a rate cut. Even if it lasted a year or so, we wanted to enjoy the lower rates and watch the BoC closely for clues.
For international readers, the way mortgage terms work in Canada is that you pick a product with your mortgage provider (bank) and select either a fixed-rate or variable-rate for a 5-year period. After the five years are up, you renew your mortgage for the next five years. We had a special option where we could go with a variable rate option (which is cheaper than fixed rate by 1/2 a percent) and if we decide to switch to fixed rate, we could switch over and lock in the fixed rate for five years from that date on. So, we will now see our monthly expenses go down by 0.25% as it is tied to the interest/prime rate. Does this mean, we will be spending our extra money? Hell no! While the rates remain low, we want to pay down as it has been our plan for the year. We want to pay down more than the minimum amount due on our mortgage as part of our 2015 goals. The extra money will mean we will end up with more going towards our principal amount than interest.