Canadian and US Dollar and Policy Rate Divergence Accelerate Mortgage Market Downside Risks

Bank of Canada’s Rate Cut vs. Federal Reserve’s Hold

The Bank of Canada (BoC) lowered its policy rate to 3.00% at its last announcement on January 29th, marking its sixth consecutive cut to stimulate the Canadian economy amid slowing growth and growing trade uncertainties. The move shifts the central bank to stabilizing its balance sheet with an end to quantitative tightening.

Meanwhile, in stark contrast, the US Federal Reserve kept its benchmark federal funds rate (FFR) steady between 4.25% and 4.50%, reinforcing a policy divergence that has widened the gap between the Canadian and US dollars. This divergence fuels increased volatility in mortgage markets, weakening the loonie and adding pressure on Canadian borrowing costs.

Why This Matters for Mortgage Markets

• Widening Interest Rate Spread: The BoC’s rate cuts are designed to lower borrowing costs, but with the Fed holding steady, the policy interest rate gap between the two countries has expanded to over 1%. This has led to a 7.7% depreciation of the Canadian dollar in 2024, with the loonie now hovering below 70 US cents.
• Higher Import Costs & Inflation Risks: A weaker dollar makes imported goods more expensive, which could drive up inflation and force the BoC to rethink further rate cuts. This stagflation risk—slower growth, rising prices, and high unemployment—complicates mortgage market conditions.
• Mortgage Rate Implications: While variable mortgages have seen immediate reductions, fixed mortgage pricing remains volatile as lenders navigate bond market fluctuations. Following the expected cut to Canada’s prime rate from 5.45% to 5.20%, bond yields dropped, but lenders may hesitate to pass on rate cuts in their entirety to borrowers with increased risk.

Note: Mortgage pricing risk premiums act as insurance for lenders, protecting them if volatility or tariff hikes increase unemployment, depress home prices, and raise mortgage risk by weakening the collateral securing their loans.

Trade War Threats and Their Impact on Canadian Borrowers

Adding to the economic uncertainty, President Donald Trump has threatened a 25% tariff on all Canadian imports starting March 4th, with further protectionist measures set for April 2nd. This escalation in trade tensions has profound implications:

• Canadian GDP Growth at Risk: The BoC’s most recent January 2025 Monetary Policy Report (MPR) estimates that a full-scale trade war could reduce GDP by 2.4% in the first year and 1.5% in the second year.
• Inflation vs. Economic Slowdown: While tariffs increase costs, they also dampen growth and job creation. The BoC must balance stimulating the economy with rate cuts while containing inflationary pressures from rising import costs.
• Housing Market Volatility: The latest BoC cut arrives just before the spring housing market, traditionally a peak buying season. While lower rates may spur demand in the short term, a prolonged trade war could derail economic confidence and slow housing activity.

How the Currency Gap is Reshaping the Canadian Mortgages

Interest rate differentials heavily influence the exchange rate between the Canadian and US dollars. Investors tend to move capital where returns are higher, meaning Canada’s lower rates make the loonie less attractive, accelerating its depreciation.

Historically, when the Canadian policy rate falls below the US rate by 1%, the loonie drops by about 1%. However, in 2024, the Canadian dollar’s depreciation exceeded this model, reflecting added exchange rate risk premiums from trade uncertainties.

• Risk Premiums and Market Speculation: Investors in currency futures and options are pricing in further depreciation, suggesting that the loonie’s weakness may persist.
• Long-Term Implications for Mortgage Borrowers: If the BoC continues cutting rates while the Fed remains in a holding pattern, mortgage holders could benefit from lower borrowing costs. However, inflation risks and currency devaluation could erode these gains over time.

What This Means for Homeowners and Mortgage Shoppers

The growing divergence between the United States and Canadian monetary policies has created a complex environment for borrowers. Here’s what Canadians should keep in mind:

✔ Variable-Rate Mortgages Offer Immediate Savings – The BoC’s cuts are lowering variable mortgage rates and corresponding monthly payments on adjustable-rate mortgages (ARM). Still, borrowers should be cautious of potential inflation-driven rate hikes if trade tensions escalate, increasing interest costs.

✔ Fixed-Rate Mortgage Pricing is Uncertain – Bond yields are fluctuating, meaning fixed mortgage rate reductions may not fully materialize if lenders adjust for increased economic risk.

✔ Home Prices May Face Conflicting Forces – Lower rates boost affordability and demand, but a trade war-driven recession could slow Canadian real estate activity.

✔ Weaker Dollar May Raise Costs for Homebuyers – Imported materials, including those used in home construction and renovations, are getting more expensive, which could raise home prices despite lower borrowing costs.

Navigating Mortgage Strategy in a Shifting Economy

With the Bank of Canada loosening policy to support growth and the Federal Reserve holding firm on inflation control, the divergence in monetary policy will continue to impact the mortgage market, exchange rates, and economic stability.

For prospective homebuyers, locking in a rate sooner rather than later may be beneficial. At the same time, existing homeowners should carefully assess mortgage renewal and refinancing opportunities amid ongoing market volatility to lock into better mortgage terms.

As Canada navigates this policy and currency gap, homeowners and borrowers must follow mortgage rate forecasts and adapt their mortgage strategies accordingly. For expert guidance on navigating these evolving mortgage conditions, consult a nesto mortgage expert today.

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