The name’s bond

Key points

• Variable-rate borrowing costs adjust quickly alongside central bank rate shifts, while fixed-rate borrowing tracks bond market yields that price in future expectations. 
• Rather than hitting everyone at once, fixed-rate costs change as debts reprice—for example, as pandemic-era fixed-rate mortgages come up for renewal.
• Diverting more income toward debt payments discourages new borrowing and dampens consumer demand, which works to cool inflation over the long run. 

With the Bank of Canada’s October 28 rate decision approaching, attention is turning to the possibility of higher interest rates, and the narrative is seemingly shifting from a matter of “if” to a matter of “when.” But what would a rate hike—the first since July 2023—actually mean for Canadians’ borrowing costs, and how quickly would they feel it?

The answer depends on a few different things. Variable-rate borrowing generally follows the lenders’ prime rates, which move closely with the Bank’s policy rate (a.k.a. the overnight rate). Fixed-rate borrowing—like fixed mortgages—depends more on bond yields, which reflect expectations for future monetary policy alongside other market forces.

In an earlier Twenty-Four, I explored the forces pushing long-term borrowing rates higher. Today, we examine how both channels reach household budgets—and ultimately influence spending and inflation.

It varies

The Bank of Canada mainly targets inflation through its policy interest rate—the rate at which financial institutions borrow from one another for a single day. This influences commercial lenders’ prime rates, which generally move alongside changes in the policy rate. The types of loans that are most directly impacted are those with variable rates, such as variable-rate mortgages, home equity lines of credit, and other loans priced relative to the prime rate.

The pass-through to borrowing costs can be substantial, as seen during the Bank of Canada’s 2022 tightening cycle. Responding to post-pandemic inflation that peaked at 8.1%, the central bank moved aggressively to cool price growth. Governor Macklem noted that the average five-year variable mortgage rate rose from 1.5% to 5.9%, and the average five-year fixed mortgage rate rose from 2.8% to 5.1%. The prime rate rose from 2.5% to 6.5%, and longer-term corporate borrowing rates were up about two percentage points.

That historical precedent, however, is not indicative of what a future hike would look like. In 2022 to 2023, the Bank of Canada raised its policy interest rate by a total of 475 basis points (4.75 percentage points) to quash runaway post-pandemic inflation. Today’s backdrop is fundamentally different: with policy rates starting from a much higher baseline and inflation pressures far more subdued, any policy tightening would likely be far smaller in scope.

Enter the bond market

Fixed-rate borrowing, like fixed mortgages, follows a different route than variable-rate loans. Government of Canada bond yields provide important benchmarks, particularly the five-year bond yield vis-a-vis five-year fixed mortgages, though lenders also take into account funding costs, operating expenses, borrower risk, and competition.

Bond markets are forward-looking. If investors expect higher policy rates in the future, yields can rise before the Bank of Canada acts. As my earlier piece discussed, if risks or long-term uncertainty rise, investors demand higher compensation for tying up their money for longer. Consequently, fixed rates can increase while the policy rate remains unchanged.

Higher long-term rates mainly reach Canadian households through mortgage renewals. The Bank of Canada estimates that over the next 12 months the last pandemic-era five-year fixed-payment mortgages—about 12% of all outstanding mortgages—will renew with payments that are about 15% higher on average. By the second half of 2027, nearly all borrowers facing large increases will have renewed.

The Bank says most borrowers have managed their higher payments so far, and lenders have not seen a broad rise in loan losses. However, elevated debt-to-income levels leave Canadian households vulnerable to job losses or unexpected expenses. 

Bottom line: When households devote more income to debt payments, less remains for other purchases or savings. Higher financing costs also discourage new borrowing, while more attractive returns on savings can encourage individuals to postpone spending. Meanwhile, businesses face financing decisions of their own. Together, these adjustments restrain demand and, over time, inflation. 

However, raising interest rates is not a magic bullet. Currently, factors such as the war in Iran are sending the energy component of inflation higher, and monetary policy has a limited impact in offsetting geopolitical factors. That being said, in Governor Macklem’s own words: “Monetary policy cannot offset the effects of tariffs or influence global energy prices. What we can do is ensure global developments don’t jeopardize price stability in Canada.”

The adjustment is gradual. The Bank of Canada’s own estimates suggest that policy rate changes take 18-24 months to have their full effects. Markets and some borrowing rates react much earlier. 

Tomorrow's announcement therefore matters both for what it changes immediately and what it signals about the path ahead. For Canadian households, the impact ultimately depends on which debts they hold—and when those debts reprice.

Answer to the previous trivia question: The first Canadian woman in space was Dr. Roberta Bondar.

Today’s trivia question: When was the Royal Commission on the Status of Women established?