Borrowing costs rise as Bank of Canada reverses course toward higher rates

OTTAWA ,01 June 2010- Borrowing costs for consumers and businesses are rising.

Canada’s chartered banks waited only a few hours before following the lead of the Bank of Canada to hike their prime a quarter point to a still modest 2.5 per cent, effective Wednesday.

But the significance of the central bank’s action Tuesday is that after three years of an ever-increasing stimulative monetary policy, the Bank of Canada has reversed course, commencing what many analysts believe will be a string of incremental rate hikes.

In doing so, bank governor Mark Carney, who has acquired a reputation for doing the unexpected, staked out new ground in becoming the first among the G7 industrial economies to move to a tightening posture. He may be alone for some time.

Most analysts don’t expect others among the big seven — which also includes the United States, the United Kingdom, Germany, France, Italy and Japan — to start raising interest rates until next year at the earliest.

The initial reaction of markets was to take the Canadian dollar down a peg — 0.95 of a cent lower to 94.88 cents US.

Scotiabank economist Derek Holt said the market reaction was in line with expectations that Carney would be more “hawkish” in his statement. Instead, the bank statement seemed to cast doubt on whether it would continue to steadily raise rates or take a pause. The next announcement date is scheduled for July 20.

“Given the considerable uncertainty surrounding the outlook, any further reduction of monetary stimulus would have to be weighed carefully against domestic and global economic developments,” the bank said.

CIBC chief economist Avery Shenfeld called Carney’s action and tone “a split decision” that suggests “even he isn’t so sure about what comes next.”

The decision will affect financial vehicles such as variable rate mortgages and lines of credit tied to the prime rate. But longer-term fixed mortgages may be unaffected, since those rates are more closely tied to long-term bond yields.

Holt said a quarter-point hike to 0.50 per cent is so small that it will have little impact on borrowing behaviour or the economy. Canadians can mitigate the higher interest rate by stretching out amortization schedules, or by paying down less principal, he explained.

Diana Dobrusevski, 27, of Toronto said she’s still happy she took out a variable-rate mortgage in October 2008 at prime minus three quarters of a per cent.

“If I were to lock into a fixed-rate mortgage right now, I’d be locking in at four or five per cent and my variable rate mortgage was at 1.75, and I guess it goes up to two per cent now but I think it will take years before it gets to four or five per cent,” she said.

Brock Parish, 40, also secured a cheap variable mortgage two years ago when he got married and bought a house in the Toronto suburb of North York.

“Variable saved me a lot of money,” said Parish, who enlisted a mortgage broker to negotiate the best deal with banks.

Parish said the Bank of Canada would have to raise rates several more times and his bank’s prime rate would have to go up from the current 2.25 per cent to five per cent before he would start to worry.

“Yesterday I was at 1.5 per cent and today I’m at 1.75,” which makes about “a $20 difference … every two weeks paying on my mortgage,” he said.

The Bank of Canada itself stressed that real interest rates in Canada remain exceptionally low.

“This decision still leaves considerable monetary stimulus in place,” it wrote in an accompanying note.

But given that consumers are already carrying record debt levels, Liberal Leader Michael Ignatieff expressed concern about the ability of Canadians to pay their mortgages if rates keep rising.

“Millions of Canadians are already spending over 50 per cent of their income on paying for their house, and we’re very concerned this is the start of a ratchet effect that’s going to put the squeeze on middle-class families.

Carney’s action would not have raised eyebrows a few weeks ago, when an entrenched global recovery appeared on solid ground. But Europe’s unfolding debt crisis and bank weaknesses in Spain have since shaken the foundations of the global outlook.

Still, Canada’s central bank said conditions have improved sufficiently to move off what had been described as an emergency rate for the economy of 0.25 per cent, where it had been since April 2009.

The bank said Canada’s economic growth has been unfolding largely as expected, citing Monday’s release by Statistics Canada that showed gross domestic product output had expanded by 6.1 per cent in the first quarter.

It said that household spending is expected to moderate, while business investment fills in the gap.

The darkening clouds on the horizon all have to do with the global economy, which the bank said remains heavily dependent on low interest rates and government spending and is becoming “increasingly uneven.”

There is strong growth in emerging economies like China and India, some consolidation in the United States and Japan and “tensions” in Europe that are likely to result in higher borrowing costs and a ratcheting down of government spending that will slow growth.

“Thus far, the spillover into Canada from events in Europe has been limited to a modest fall in commodity prices and some tightening in financial conditions,” the bank said.

But it noted that Europe remains an important downside risk for the global economy, which would likely have spillover effects for Canada

Article By Julian Beltrame, The Canadian Press 01 June 2010 in YAHOO FINANCE

(The comments contained on this site are for information purposes only and do not constitute legal advice.)

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