The Chance of Negative Rates Remains

“We are not actively discussing negative interest rates at this point, but it’s in our toolkit and never say never.”

Bank of Canada Governor, Tiff Macklem

That comment from Canada’s monetary kahuna, Tiff Macklem, put a glimmer of hope in the eyes of variable-rate mortgagors this week.

By leaving the door open to sub-zero rates, even if just a crack, some rate floaters are remaining optimistic about the potential for further prime rate cuts.

But for prime rate to drop again, Canada’s overnight rate would have to fall to 0% or below, something the BoC doesn’t relish.

In 2015, the Bank told us, “experience indicates that negative interest rates are indeed a viable policy tool.” But in May, Macklem reminded everyone there are “disruptive effects of going negative.”

“It’s hard to explain to depositors why their deposits are shrinking in their account when they’re not taking any money out,” he said. (Meanwhile, Canadian bank fees—among the highest in the world—shrink deposits every day.)

Macklem continued, “When you’ve already got a disrupted financial system, you may want to be hesitant about introducing a new source of disruption. So, when you look at the current situation, yes, I’m quite comfortable with the effective lower bound where it is (at 0.25%).”

Macklem’s predecessor, Stephen Poloz, was also less than embracing of sub-zero rates, stating:

• “At this stage, it would be not sensible to think of interest rates going lower than this.”
• “We don’t like the idea…It’s not a happy place for the banking system.”
• “We consider this (0.25%) to be the effective lower bound.”

Clearly, there would have to be almost nothing left in the BoC’s arsenal to compel it to risk such economic distortions with a minus 0.25% overnight rate.

And those distortions would be very real: asset and housing bubbles, excessive risk-taking, unsustainable debt loads, a less resilient financial system, a disincentive to save and many more.

That’s not to mention the fact that smart people argue over whether negative rates even work. “…Consumers and businesses respond less to interest rate declines when interest rates are already very low,” Poloz once said.

The BoC is well aware of all these downsides and understands that negative rates are the “nuclear” option.

Where Bets Are Now Being Placed

Implied future rates in the bond market suggest a slightly higher probability that the overnight rate will be lower one year from now than higher. But it’s so minor a signal as to almost be meaningless.

Most professional rate watchers project the overnight rate will remain stuck in a sideways channel until at least 2023, according to a recent Bloomberg economist survey.

Others believe the wisdom of the consensus will be turned on its head, given:

• Unprecedented economic stimulus
• Looser inflation policy
  • The Fed, and potentially Canada, will let inflation run hot
  • That could eventually trigger a government bond sell-off (bond prices and rates move in opposite directions)
• Mounting credit fears in the bond market
  • south of the border, for example, public debt levels will soon eclipse economic output for the first time ever
  • extreme deficits, particularly persistent extreme deficits, are correlated with higher interest rates
• Inflationary supply bottlenecks from COVID and trade frictions
• Potential for a sooner-than-expected end to quantitative easing as the economy recovers.

So, if you’re looking for reasons why negative rates won’t happen, they’re not hard to find. There are even outlier economists—like Citigroup—who expect 100 bps of rate hikes in 2022.

All this is not to say rates are imminently in danger of blasting off. They’re not. It’s simply to acknowledge that despite the BoC seeming somewhat open-minded to negative rates, it’s still exceptionally unlikely we’ll see them in this credit cycle.

“Fiscal policy tends to be a more powerful tool than monetary policy in…extreme circumstances,” Poloz once explained. That’s why it’s not surprising that the BoC wants Ottawa to open its purse strings more. And the Liberal-NDP alliance seems all too willing to oblige.

With Ottawa resigned to spending its way out of this mess, economic deterioration would have to get far uglier for the BoC to tap its last line of defence: more rate cuts.

And let’s not forget two other truths:

1) the BoC still has other tools that it prefers over negative rates, like additional large-scale asset purchases, collateralized funding for banks at subsidized rates and forward guidance (e.g., pledging to keep rates low for years).

and…

2) Even if rates did go negative, it doesn’t mean prime rate would drop in lockstep. Banks have proven in the past that they’re more than willing to deviate from the BoC and not cut prime to save profitability.

All this is to say, if you’re Lloyd Christmas wondering whether prime rate could sink another 25- to 50-bps then, “yes, there’s a chance.” But not enough of one to hitch your wagon to a variable.