Variable Mortgage Rates Grow More Appealing for Canadians

The U.S. Federal Reserve raised its policy rate from 0.50% to 0.75% last week, as expected. And while the Fed essentially left its previous projections for the U.S. economy intact, it is now positioning the U.S. bond market for three additional rate hikes in 2017 (up from two hikes in its prior forecast).

The Fed’s forecasts have been wide of the mark for years (it had previously forecast three hikes in 2016) but bond-market investors seem to be buying the Fed’s view more so now than they have over the past several years, and that has pushed U.S. bond yields sharply higher.

The current narrative is that President-elect Trump will push through corporate tax cuts that will spur business investment and increase the demand for (and cost of) labour, and that he will also introduce massive new infrastructure-spending initiatives. If these developments play out as expected they will portend higher inflation, and investors are driving up U.S. bond yields in anticipation of this outcome (and they are taking Canadian bond yields, and our fixed mortgage rates, along for the ride).

Time to scratch my contrarian itch.

While the two Trump-led initiatives outlined above would be inflationary on their own, we need to consider their impact against a broad backdrop of other factors. For starters, will President-elect Trump’s own party support tax cuts that increase the deficit? I doubt it. And will they support fiscal stimulus that does the same, especially at a time when Federal Reserve Chair Yellen has just expressed her unequivocal opinion that the U.S. economy doesn’t need fiscal stimulus at this time?

Even if those tax cuts are pushed through, will businesses suddenly find the confidence to invest in productivity enhancements and capacity expansion with President-elect Trump holding fast to his protectionist agenda? If long-standing trade deals are under threat, is now a good time to be doubling down on investment, or would the safer option be to return any tax windfalls to shareholders? I know what I would be doing if I were sitting in a corner office and had to make that call.

What about the long-term factors that have pushed inflation down to its current low levels? President-elect Trump can’t do anything about the inherently disinflationary effects of an aging population. The U.S. economy is cranking out new retirees at record rates and will continue to do so for years to come. The surging U.S. dollar that has accompanied the recent spike in U.S. bond yields is another powerful deflationary force and record U.S. debt levels will continue to be a lode stone that exerts a inexorable drag on U.S. economic growth rates.

I could go on, but suffice it to say that when I look at the severity of the recent bond-yield run up I am reminded of a famous observation by Benjamin Graham about financial markets being a voting machine over the short term but a weighing machine over the long term. While there is no denying which way the momentum arrow is pointing at the moment, I think the threat of higher inflation that has caused the recent bond-yield spike will not materialize as the market now expects.

Of course, if you need a mortgage in the near future that prediction offers only cold comfort. Perhaps this next section will provide you with something more tangible to work with.

The gap between our five-year fixed and variable mortgage rates has expanded of late, but it is still only about 0.50%, which is considered narrow by historical standards. Most borrowers have looked at that gap for some time and decided that they weren’t getting paid enough of a discount to take on variable-rate risk, and rightly so, but circumstances have evolved to the point where this thinking should now be reconsidered.

Five-year fixed rates have surged higher because they are priced on Government of Canada (GoC) five-year bond yields, which have been pulled along by their U.S. equivalents. But five-year variable mortgage rates haven’t budged (unless you borrowed from TD) and most observers believe that the Bank of Canada is still more inclined to cut its policy rate rather than to raise it. Given that, and because we find ourselves in strange times today, if you need a mortgage today and think that five-year fixed-rate pricing is temporarily out of whack with longer-term fundamentals, locking in a variable rate (or a shorter-term fixed rate) makes sense.

Down the road, if five-year fixed rates normalize you will have the option of converting your five-year variable rate to a five-year fixed rate at no cost. You can also set your payment as if you had locked in today’s more expensive five-year fixed rates and then your interest-rate saving will go toward paying off your mortgage more quickly.

Five-year GoC bond yields rose by thirteen basis points last week, closing at 1.22% on Friday. Five-year fixed-rate mortgages are available in the 2.59% to 2.84% range, with additional premiums now being added for refinances (+0.10%), rental properties (+0.25%) and extended amortizations (+0.10%). These new premiums are a result of regulatory changes and are explained here. Five-year fixed-rate pre-approvals are now offered at around 2.79%.

Five-year variable-rate mortgages are still available in the prime minus 0.40% to prime minus 0.60% range, which translates into rates of 2.30% to 2.10% using today’s prime rate of 2.70%.

The Bottom Line: U.S. bond market investors are subscribing to the U.S. Federal Reserve’s more bullish view of inflation, but for the reasons outlined above, I am not convinced that events will play out as the consensus now believes. If you’re in the market for a mortgage today and are willing to consider alternatives to a five-year fixed-rate mortgage after the recent rate spike, I think five-year variable rates or shorter-term fixed rates are worth considering.  These options will buy you some time for Canadian bond yields to fall further behind their U.S. counterparts as our economies progress along very different trajectories as expected (which I recently wrote about here). While employing this strategy comes with the risk that my rate view may be proven wrong in the fullness of time, nothing ventured, nothing gained.