Latest / How Canadian Markets Work / Episode 27: Unconventional Policy (When Rates Hit the Floor)

Transcript

Episode 27: Unconventional Policy (When Rates Hit the Floor) · How Canadian Markets Work

0:00
I want you to just take a second, maybe take
0:02
a breath and think about the last time you were...
0:05
scrolling through your phone. Or maybe you were
0:07
driving, you know, just listening to the news.
0:09
Yeah, just going about your day. Right. And you
0:12
catch this headline about a central bank interest
0:14
rate decision. And if you are like most people,
0:18
it probably felt, I don't know, incredibly distant.
0:20
Oh, totally. Very theoretical. Exactly. Just
0:23
a bunch of economists in a boardroom somewhere
0:25
tweaking a decimal point. And it seems completely
0:29
disconnected from your daily life. You know your
0:32
grocery bill your stress levels. Well financial
0:35
news often wraps itself in this really impenetrable.
0:39
kind of clinical language. I mean, the terminology
0:42
is almost designed to sound abstract. Yeah, it
0:44
really creates a barrier. It does. It creates
0:46
this wall between the mechanics of the economy
0:48
and the reality we actually experience in our
0:51
own homes. When you hear about, like, basis points
0:54
or overnight targets, it's just very easy to
0:56
tune out. It is. But the truth is, that single
1:00
decimal point is intimately connected to almost
1:02
every financial reality you experience. So welcome
1:06
to today's deep dive. We are really glad you're
1:08
here with us. They are. And our mission today
1:10
is to gently pull back the curtain on the plumbing
1:14
of the financial system. We are going to trace
1:17
exactly how a single, you know, seemingly irrelevant
1:20
interest rate ripples out through the pipes to
1:23
dictate your mortgage, your savings, the value
1:25
of the currency in your pocket and even your
1:27
employer's hiring plans. We are taking our time
1:30
today. We're just going to slow down and map
1:32
out this machinery together. I love that approach,
1:36
because to really understand this machinery,
1:38
we have to start at the very source of those
1:40
ripples, which is the central bank's policy rate.
1:43
OK. And the core concept that surprises so many
1:48
people is that this big headline policy rate
1:50
is really just a target for loans between financial
1:54
institutions. Wait, just between the banks? Just
1:55
between the banks, overnight. Literally for a
1:58
single night. Oh, wow. Yeah at the end of every
2:01
business day banks need to settle their accounts
2:03
with each other You know some have a little extra
2:05
cash some are a little short So they lend to
2:07
each other overnight to balance the books, right?
2:10
Okay, and the thing is you will never touch this
2:13
rate I mean, no financial product you own references
2:17
it directly. It basically governs a closed market
2:20
that you cannot and honestly will never access.
2:23
So if it is just banks lending to other banks
2:26
while the rest of us sleep. the immediate question
2:29
is why you or I should care at all. That is the
2:32
big question. Right. The thing felt like the
2:35
wholesale water pressure at your municipal water
2:38
plant. Oh, that's a good way to look at it. Yeah,
2:39
because you never interact with the plant directly.
2:41
You couldn't even get past the front gate if
2:43
you tried. No, definitely not. But if the engineers
2:46
at that plant turn the main dial and increase
2:48
the pressure, well, the flow in your kitchen
2:51
sink changes almost instantly. You feel the result
2:54
of their action even if you never saw the engineers
2:57
actually turn the dial. That is exactly it. The
3:00
transmission mechanism works precisely in that
3:02
manner and we call this the borrowing cost channel.
3:05
Borrowing cost channel. OK. Right. So when the
3:08
central bank raises that overnight rate it immediately
3:10
becomes more expensive for regular everyday commercial
3:13
banks to fund their own daily operations. Their
3:16
underlying costs go up. And I'm guessing they
3:19
don't just eat that cost out of the goodness
3:20
of their hearts. No absolutely not. Banks are
3:24
profit -driven institutions. They do not absorb
3:27
those costs. They pass them right along to the
3:29
consumer. So the moment their funding costs rise,
3:32
they increase their own prime rate, which is
3:34
the baseline rate they use to charge their best
3:37
customers. And this happens fast, usually within
3:40
a matter of days. OK, so the prime rate is the
3:42
water finally arriving at the kitchen sink. Beautifully
3:45
put, yes. If you have a variable rate mortgage
3:48
or maybe a home equity line of credit or really
3:51
many types of personal loans, your interest rate
3:54
is explicitly tethered to that prime rate. Oh,
3:56
I see. So when the overnight rate changes, your
3:59
bank changes the prime rate and your variable
4:02
borrowing costs move in absolute lockstep. This
4:05
is the fast channel of monetary policy. The effect
4:08
is nearly instantaneous. Okay, that makes perfect
4:11
sense for variable rates. The pipe is directly
4:13
connected. But if I had a fixed rate mortgage,
4:16
I would assume my sink is connected to an entirely
4:18
different plumbing system. That is a very common
4:21
assumption. Yeah, because my rate is locked.
4:24
Right. So the central bank's daily tweaking shouldn't
4:27
affect the cost of a new fixed mortgage at all.
4:29
Well, you are right that fixed mortgages operate
4:32
on a completely different set of mechanics. They
4:35
do not track the overnight rate or the prime
4:37
rate. Instead, they track The bond market. The
4:40
bond market. OK. Yes. So if you want, say, a
4:43
five -year fixed mortgage, your bank needs to
4:46
ensure they can lock in their own funding for
4:48
five years to lend to you safely. That makes
4:51
sense. Right. So they look at the current payout
4:54
or the yield of a five -year government bond.
4:57
If bond investors are demanding a higher return
5:00
to part with their money for five years, well,
5:02
your bank is going to charge you a higher fixed
5:04
rate for a five -year mortgage. Wait, hold on.
5:07
Bond markets are driven by human expectations,
5:10
right? Investors are always out there trying
5:12
to guess what will happen next year, or I don't
5:14
know, three years from now. Exactly. Wait, so
5:16
if bond markets move based on expectations, my
5:19
fixed mortgage rate can go up before the central
5:21
bank actually does anything. Yes. That is exactly
5:25
what happens. Bond markets are constantly pricing
5:28
in the future. So if investors believe that the
5:32
central bank is eventually going to raise rates
5:33
to fight inflation, they demand higher returns
5:36
on bonds today. Because they see it coming. Right.
5:40
And consequently, fixed mortgage rates will increase
5:42
before the central bank even makes an official
5:44
announcement. The expectation itself does the
5:48
heavy lifting. That is wild. It really is. You
5:51
might be completely baffled to see your mortgage,
5:53
quote, jump when the central bank did literally
5:55
nothing that month. But the market had already
5:58
moved based on what they anticipate will happen
6:00
next year. That is so fascinating. And, you know,
6:03
seeing how those two distinct pipes work, the
6:06
variable prime rate pipe and the fixed bond market
6:08
pipe, it brings up this fascinating structural
6:11
difference between countries. It really does.
6:13
It changes everything. Yeah. The specific way
6:15
a country structures its mortgages fundamentally
6:18
changes the vulnerability of its entire population.
6:20
Like, the notes we have on Canadian market mechanics
6:23
highlight a massive defining contrast. between
6:27
Canada and the United States. Massive is the
6:29
right word. The structural difference between
6:31
the two nations dictates entirely different economic
6:34
realities. So in the United States, the absolute
6:38
gold standard for homeownership is the 30 -year
6:41
fixed -rate mortgage. You buy a house, you lock
6:44
in your interest rate, and you know your exact
6:47
monthly payment for the next three decades. Three
6:49
decades? That is such a long time to have certainty.
6:52
It is incredible certainty. The central bank
6:54
could raise rates to the moon to fight inflation,
6:56
and the American homeowner's monthly budget does
6:59
not budge a single cent. It sounds like a financial
7:02
fortress. You know, you buy the house, you call
7:04
up the drawbridge, and the weather outside simply
7:07
does not matter. A perfect metaphor. But the
7:10
Canadian system sounds much more like, um...
7:12
Signing a commercial lease that just keeps expiring.
7:15
That is exactly what it is. The standard in Canada
7:18
is a five -year term on a 25 -year amortization.
7:22
Meaning what, exactly? To put it simply, it takes
7:25
25 years to pay off the house entirely. But the
7:28
contract you sign with the bank only lasts for
7:30
five years at a time. Oh, wow. Yeah. Every five
7:32
years, your lease runs out. You are forced to
7:35
step outside your financial fortress, look at
7:38
whatever the economic weather happens to be on
7:40
that specific day, and renegotiate your interest
7:43
rate based on the new environment. The vulnerability
7:46
there is just staggering. I mean, American households
7:48
are shielded for a generation while Canadian
7:51
households bear the full brunt of national interest
7:54
rate risk. Entirely on their own shoulders, yes.
7:56
Repricing across the country is either continuous
7:59
for variable holders or it's staggered in these
8:02
brutal five -year waves. So Canadian monetary
8:06
policy must be incredibly potent. Extremely potent.
8:10
Because every single time the central bank turns
8:12
the dial, they are actively squeezing millions
8:15
of households who simply have no choice but to
8:18
renew. Yes. The central bank gets a much faster,
8:21
much harder economic effect per rate change than
8:24
the US Federal Reserve does. The transmission
8:27
just forced upon the population. You really feel
8:29
it. You do. And to see how this macroeconomic
8:31
theory hits the kitchen table, we can just observe.
8:34
of how this structural difference actually feels
8:36
for three specific types of households. Let's
8:38
do that. So imagine household one, they have
8:41
a variable rate mortgage. We know they feel the
8:43
height immediately through the fast channel.
8:45
But there is a very specific product here that
8:48
I think confuses people. The variable rate with
8:50
a fixed monthly payment. Right. Like if my payment
8:53
stays at $2 ,000 a month, no matter what the
8:56
central bank does, I am safe from the hike, right?
8:59
My monthly budget does not change, so I don't
9:01
feel the squeeze. Oh, that is one of the most
9:04
dangerous misconceptions in personal finance
9:06
right now. Really? You are not safe. The hit
9:09
is actually stealthier and potentially way more
9:12
destructive over time. How so? Well, when your
9:15
payment holds steady at two thousand dollars,
9:18
but the underlying interest rate climbs, the
9:21
math inside that payment changes drastically.
9:23
OK, I'm following. A year ago, perhaps a thousand
9:26
dollars of that payment went to reducing your
9:28
actual debt. and $1 ,000 went to the bank as
9:30
interest. But today, after rate hikes, $1 ,900
9:35
might go straight to the bank's profit, and you're
9:37
only paying off $100 of your house. So I am writing
9:41
the exact same check, but my debt is no longer
9:43
shrinking. Barely shrinking at all. And in extreme
9:46
cases, your fixed payment might not even cover
9:49
the interest anymore. Wait, what happens then?
9:51
The unpaid interest just gets added onto your
9:54
total loan. Your debt actually grows every single
9:57
month, even while you continue to make your full
9:59
payments. That is terrifying. It is a silent
10:02
squeeze. It erodes your home equity without you
10:05
ever feeling it in your daily checking account.
10:07
A completely stealth hit. Okay, now, imagine
10:11
household two. Okay. They are sitting on a five
10:15
-year fixed mortgage they signed two years ago,
10:17
back when rates were sitting at rock bottom.
10:20
Now, the central bank raises rates today. Household,
10:23
too, feels absolutely nothing, right? Their payment
10:25
is the same. Their debt reduction is exactly
10:28
the same. They are safe in the fortress. They
10:30
are the fortress, yes. But they are living with
10:32
a ticking clock. Oh, the renewal. Right. In three
10:35
years, their five -year term expires. They face
10:38
a single unavoidable conversation at their renewal.
10:41
And at that exact moment, Their monthly payment
10:43
will step up to reflect three years of accumulated
10:46
rate hikes all at once. With no warning. There
10:48
is no adjustment period. It is a sudden, jarring
10:52
shock to their cash flow, where their housing
10:55
costs might jump by many hundreds or even thousands
10:58
of dollars overnight. The psychological weight
11:00
of watching that renewal date approach can be
11:03
just immense. I can only imagine. But what about
11:06
Household 3, the renter? Ah, the renter. They
11:09
do not own a home. They do not have a mortgage.
11:11
They are just completely opted out of this specific
11:14
financial game. Nobody escapes the transmission
11:17
mechanism. Really? Nobody. Nobody. Even without
11:21
a mortgage, the renter feels the impact. deeply,
11:24
primarily through the labor market. How does
11:26
that work? When the central bank raises the overnight
11:28
rate, the commercial bank's borrowing costs go
11:30
up, like we talked about. Right. The commercial
11:32
bank then charges more for business loans. So
11:35
the renter's employer suddenly finds that expanding
11:37
the business or simply maintaining their credit
11:40
lines is much more expensive. Oh, I see. The
11:43
business has less free cash, expansion plans
11:46
get shelved, hiring freezes, wage increases get
11:49
smaller or disappear entirely. And I imagine
11:52
their housing costs are immune either, right?
11:54
Because the landlord owns the building and the
11:56
landlord likely has a mortgage. Exactly. So if
11:58
the landlord's borrowing costs are rising, they
12:01
will try to pass that margin squeeze directly
12:03
onto the renter. They certainly will try. The
12:06
Ripples always find the shore. And, you know,
12:09
we can also widen the lens to look at the slightly
12:12
less visible channels where this single overnight
12:15
rate alters reality. Let's do it. The first is
12:18
the asset price channel. which is often referred
12:21
to as the wealth effect. The wealth effect. OK,
12:25
financial textbooks describe this by saying future
12:28
cash flows are mathematically worth more today
12:30
when discounted at a lower interest rate. A very
12:33
dry way to say it. Yeah, that language flies
12:35
right over the heads of anyone not actively working
12:38
on Wall Street. What is the actual on the ground
12:40
mechanism driving this wealth effect? Think about
12:43
where people put their money when savings accounts
12:46
pay almost nothing. If interest rates are incredibly
12:49
low, keeping your money in the bank feels like
12:51
a losing strategy. Right. You're essentially
12:53
losing to inflation. Exactly. So investors get
12:56
desperate for returns. They pull their money
12:58
out of safe savings imported into the stock market,
13:01
or they bid up the prices of real estate. That
13:04
flood of money pushes asset prices higher. OK,
13:07
that makes sense. Higher rates do the exact reverse.
13:09
Suddenly, a guaranteed 5 % return in a safe bank
13:13
account looks very attractive. Money flows out
13:16
of risky stocks and real estate, and those asset
13:19
prices fall. So when people look at their retirement
13:22
accounts or their home appraisals and see massive
13:24
gains, they simply feel wealthier. They do. A
13:27
homeowner might not have more cash in their actual
13:29
pocket, but they feel comfortable taking out
13:31
a line of credit to, say, renovate the kitchen
13:33
or buy a new car. Yes. They spend more in the
13:36
real economy. And then when rates rise and those
13:38
paper values drop, that confidence vanishes and
13:41
spending completely dries up. That is the wealth
13:44
effect. in action. But this effect must be highly
13:46
uneven, right? Like, it only benefits people
13:49
who already own assets. Absolutely. It actively
13:52
widens the gap between asset owners and wage
13:54
earners. Low rates supercharge the wealth of
13:58
people who already own homes and stocks, while
14:00
making it much harder for wage earners to buy
14:02
their first home because prices are being bid
14:04
up so aggressively. It's a tough dynamic. Yes.
14:07
Another broad channel is the exchange rate. When
14:10
a country raises its interest rates relative
14:12
to the rest of the world, It attracts foreign
14:15
capital. OK. Global investors always want to
14:17
park their money where it earns the highest safe
14:19
yield. So that sudden influx of demand to buy
14:23
your country's currency strengthens the domestic
14:25
dollar. So what does this all mean? Like if the
14:28
dollar in my pocket gets stronger because of
14:30
higher rates, how does that translate at the
14:32
grocery store? Is a strong dollar a good thing
14:35
or a bad thing? It actually cuts both ways simultaneously.
14:37
Really? Yeah. A stronger domestic dollar makes
14:40
imported goods much cheaper. The electronics
14:44
you buy, your imported groceries, your overseas
14:46
vacations, they all cost less in your local currency.
14:49
Oh, that sounds great. It does. And it directly
14:52
helps the central bank lower inflation. But on
14:56
the flip side, a strong dollar makes your country's
14:59
exports much more expensive for the rest of the
15:01
world to buy. Oh, I see. They become less competitive
15:04
on the global market. That hurts domestic manufacturers,
15:07
farmers, and exporters, which slows down the
15:10
domestic economy and can result in significant
15:12
job losses. So it is a constant balancing act
15:16
between crushing inflation through cheap imports
15:18
and protecting domestic jobs. Very much so. And
15:21
there's one more channel worth discussing, which
15:24
relies entirely on human psychology, the expectations
15:28
channel. Psychology, really? Yes. Credibility
15:30
is a tangible, heavy tool for a central bank.
15:34
If the public, the labor unions and the financial
15:36
markets genuinely believe that the central bank
15:38
will do absolutely whatever it takes to control
15:40
inflation, That belief alone does half the heavy
15:44
lifting. Just the belief. Just the belief. Workers
15:46
might moderate their demands for massive wage
15:48
increases, and businesses might hesitate to aggressively
15:51
raise their prices simply because they expect
15:53
inflation to fall back in line anyway. That's
15:56
fascinating. But if a central bank loses that
15:59
public credibility, controlling inflation becomes
16:02
exponentially harder, requiring much more aggressive
16:05
rate heights to force the issue. Wow. You know,
16:08
seeing the immense power of these channels, the
16:10
mortgages, the currency, the psychology, we have
16:13
to confront the terrifying reality of trying
16:15
to actively steer this machine. It is quite a
16:18
machine to steer. Right. And the people turning
16:19
the dials are operating with a severe disadvantage.
16:22
They are. The lag is probably the most daunting
16:25
aspect of monetary policy. The lag. Yes. When
16:28
the central bank makes a rate decision today,
16:31
the full economic effect of that specific decision
16:34
will not be completely felt in the real economy
16:36
for... roughly 18 months to two years. Okay,
16:39
let's unpack this. Think about adjusting the
16:42
temperature in a shower in an old building with
16:44
incredibly long pipes. Oh, I hate those showers.
16:48
Right. You turn the dial to cold, nothing happens,
16:50
you're still getting scalded, so you turn the
16:52
dial even further. A minute later, all that freezing
16:55
water finally arrives at the shower head and
16:57
you are just shivering. That is exactly what
17:00
it feels like. So the central banks is essentially
17:02
setting policy today for a future economic reality
17:05
they cannot possibly observe. They are reading
17:09
an economic thermometer that is weeks or months
17:11
old, adjusting a dial today and waiting two years
17:14
for the water to hit the sink. Yes. The risk
17:16
of a massive overshoot seems incredibly high.
17:19
It is the defining challenge of central banking.
17:21
They are always acting on a forecast, and forecasts
17:24
are inherently flawed. Because it's just a guess.
17:27
Right. By the time today's aggressive rate hikes
17:29
fully hit the economy, the economy might already
17:32
be plunging into a severe recession that actually
17:35
requires immediate rate cuts. Oh, man. Which
17:38
brings us to the ultimate dilemma, the conflict
17:41
of mandates. What does that mean? Raising rates
17:44
to crush inflation puts immense crushing stress
17:47
on borrowers, on households, and on the stability
17:51
of the commercial banks that lent them the money.
17:53
The central bank is constantly forced to weigh
17:55
the absolute necessity of inflation control against
17:58
the very real threat to financial stability.
18:00
If they turn the dial too hard, the pipes burst.
18:03
If the people running the water plant are essentially
18:05
driving in the dark and we are the ones who feel
18:07
the sudden changes in temperature, how do we
18:09
put on a raincoat? We have to defend ourselves.
18:12
Yeah. What practical defensive strategies can
18:15
you, the listener, use today to navigate this
18:18
plumbing? Well, the first strategy is remarkably
18:21
simple, but vital. Know your renewal date. Just
18:25
knowing the date. Yes. If you live in a system
18:27
like Canada, With five -year expiring terms,
18:31
your mortgage renewal date is arguably the single
18:34
most consequential financial date in your life.
18:37
Write it down. Put it on your calendar a full
18:39
year in advance. Don't let it sneak up on you.
18:42
Exactly. Do not let it startle you. You need
18:44
time to review your budget and prepare for the
18:46
cash flow shock if rates have risen substantially
18:48
since you originally signed. And when you actually
18:51
reach that renewal date, you face the choice
18:53
between a fixed and a variable rate. Many people
18:56
approach this by trying to outsmart the market,
18:58
right? All the time. They read financial news
19:00
and try to predict what the central bank will
19:02
do next. Which is a mistake. Yeah, you are never
19:04
going to out -trade the global bond market. Instead,
19:07
you have to view this as choosing the specific
19:10
shape of risk you want to invite into your life.
19:12
The shape of risk. I love that phrasing. Yeah.
19:15
Choosing a fixed rate means you want absolute
19:17
certainty now, but you willingly accept the risk
19:20
of a massive abrupt step change in your payments
19:23
five years down the road. Right. Choosing a variable
19:25
rate means you are accepting continuous rolling
19:28
adjustments to your life in real time. Neither
19:31
is perfectly safe. They are simply different
19:34
shapes of discomfort. Framing it as the shape
19:36
of risk is definitely the healthiest approach.
19:38
Yeah. You must match that shape to your personal
19:41
cash flow stability and your own psychological
19:44
tolerance for stress. Exactly. Now there is another
19:47
defensive strategy and it's regarding your savings.
19:50
Here's where it gets really interesting. Oh yes.
19:52
We spent time outlining how banks pass rate hikes
19:55
onto borrowers almost instantly through the fast
19:58
channel of the prime rate. But the speed at which
20:00
they pass those higher rates on to say is entirely
20:03
different. Commercial banks are incredibly slow
20:06
and grudging when it comes to rewarding savers.
20:08
So slow. If the central bank has been aggressively
20:12
raising rates you must proactively check the
20:15
interest yield on your savings account. Banks
20:18
rely heavily on customer inertia. They just assume
20:21
you won't move your money. Right. They will not
20:23
automatically bump up your yield to match the
20:26
new higher -rate environment. You often have
20:28
to make a phone call, negotiate, or manually
20:31
move your money to a different high -yield product
20:33
to force them to give you the return you deserve.
20:36
You always have to advocate for your own money.
20:38
The system will not automatically optimize for
20:40
your benefit. It requires active participation.
20:43
The financial system is a deeply interconnected
20:46
ecosystem. An action taken at the very center
20:49
inevitably washes up on your shores. Understanding
20:52
those underlying tides does not mean you can
20:55
control them, but it means you can prepare your
20:57
own defenses. That is so beautifully said. We
21:00
started with a single invisible overnight interest
21:03
rate, you know, just the sterile number in a
21:05
news headline, and we followed it through the
21:07
pipes. We watched it instantly move the prime
21:09
rate, tilt the bond market based on expectations.
21:12
dictate the value of our currency, and quietly
21:16
reshape the financial reality of every homeowner
21:18
and renter in the country. It touches everything.
21:20
It really does. But before we sign off, there
21:22
is one final, unmentioned scenario to just sort
21:25
of mull over. OK, let's hear it. We discussed
21:28
how Canada's five -year mortgage structure acts
21:30
as a brutal accelerator when rates go up, right?
21:33
Putting a quick, tight squeeze on households
21:35
to fight inflation. Right. But what happens when
21:38
the central bank desperately wants to cut rates
21:41
to stimulate a struggle gasping economy. If millions
21:45
of homeowners are trapped inside high fixed rates
21:48
that they signed three years prior, their monthly
21:50
payments will not drop. They do not get the financial
21:54
relief needed to go out and spend money in their
21:56
community. That is a huge problem. Are they effectively
21:59
unable to help stimulate the economy until their
22:01
arbitrary renewal date finally arrives? Does
22:05
the expiring lease model trap the cure? just
22:08
as efficiently as it accelerated the pain? The
22:10
asymmetry of our financial plumbing is a profound
22:13
structural question, and one well worth thinking
22:16
about as we watch the next cycle unfold. Absolutely.
22:19
Thank you so much for joining us on this deep
22:21
dive. Keep questioning the mechanics of the world
22:24
around you. Check the right on your savings account
22:26
this week, and we will catch you on the next
22:28
deep dive.