Uncertainty Reigns at The Bank of Canada

The Bank of Canada (BoC) left its overnight rate unchanged last week, which was widely expected, and that means that variable mortgage rates should continue to hold steady. (I say “should” to allow for the possibility that another lender follows TD Bank and arbitrarily raises its prime rate for its entire book of existing variable-rate borrowers.)

The BoC also published its latest Monetary Policy Report (MPR), which provides us with its assessment of current economic momentum both at home and abroad, and includes projections of how the Bank thinks our economy will progress in future.

If you’re trying to get a handle on where our mortgage rates may be headed over the next several years, this document gives you a good idea of our policy makers’ thinking.

Bluntly put, the overriding theme of this MPR was uncertainty, and today’s post will provide a summary of the January MPR’s key points, along with my take on what the BoC said.

International (Non-U.S.) Commentary

• “The global economy improved in the second half of 2016, and economic growth is projected to continue to strengthen over the project horizon.” The BoC maintained its forecast for global growth in 2017 at 3.2%, and raised its forecast for 2018 from 3.5% to 3.6%. The Bank noted “considerable uncertainty” in its forecasts, “particularly concerning trade” and fair enough on that point. With the newly inaugurated U.S. President Trump in office, anyone trying to forecast future outcomes can be forgiven for offering a wider-than-normal range of possibilities.
• The BoC raised its forecast for Japan’s GDP from 0.6% to 1.0% in 2016, from 0.8% to 1.0% in 2017, and from 0.8% to 0.9% in 2018. It believes that the weaker yen combined with “stronger external demand coming from the United States” will boost output. It noted that Japan’s economic data surprised to the upside in the third quarter of last year and “indicate[d] greater momentum than previously assessed.” Although Japan’s most recent data surprised to the upside, a broader look at Japan’s economy still shows its government debt-to-GDP ratio at 230%, which is the highest in the world. (With second-place Italy clocking in at 132%, you have an idea of just how much government debt Japan has relative to that of everyone else.) While the BoC sees Japan’s economic momentum improving, its hard to imagine how that country can achieve any sustainable economic improvement until its massive debt burden is addressed.
• “In the euro area, economic activity and employment growth have held up despite financial system stresses in some countries and elevated political uncertainty, particularly around the consequences of Brexit.” The uptick in euro area data doesn’t change my belief that, over the longer term, the collapse of the region’s single currency is inevitable. In that context, the uptick in the euro area data is nothing to get too excited about, especially as the region is in the midst of trying to navigate Brexit, the Italian banking crisis, elections in Germany, France and Holland, and the ongoing refugee crisis (to name only the region’s most pressing challenges).
• “The Chinese economy continues to rebalance toward a more sustainable growth path, broadly in line with the expectations set out in the October Report.” The BoC forecasts Chinese GDP to decrease from 6.6% in 2016 to 6.4% in 2018 as business investment slows and the country takes steps to “address overcapacity in some segments”. The Bank also expects residential investment to slow as the government tries to “curb rapid growth in housing and sales prices”. China is the marginal buyer of the world’s commodities and that means that Chinese economic growth rates have a big impact on our own economic momentum, even though we don’t engage in much direct trade together. For example, economist David Rosenberg recently noted that there is now an 85% correlation between the Toronto Stock Exchange and the Shanghai index. As China tries to reduce its dependence on massive infrastructure investment while it transitions its economy to one that is more service based, its demand for commodities should fall. As that happens, we should expect to see commodity prices weaken, along with our economic momentum.

In summary, outside of North America, the BoC’s uncertainty theme is well illustrated by Japan’s massive debt overhang, the euro zone’s litany of ongoing crises (take your pick), and the continued rebalancing of China’s massive economy.

U.S. Commentary

• In the U.S. “growth is expected to rebound in the second half of 2016 after a weaker first half, in part reflecting the positive contribution of inventory investment.” Interestingly, while inventory investment temporarily boosts growth, that inventory must be sold before it will be clear whether that investment fueled increased current demand or just future demand brought forward (at the expense of future growth). The Bank revised its U.S. growth projections up from 1.5% to 1.6% in 2016, from 2.1% to 2.2% in 2107, and from 2.0 to 2.3% in 2018.
• The Bank noted that U.S. bond yields have increased recently, and that this increase reflects a shift in market expectations based on the belief that fiscal expansion will bring “higher growth, inflation, and policy rates”. For its part, the BoC is forecasting that this expansion will “boost the level of [U.S.] GDP by about 0.5 per cent by the end of 2018.”  As I have written previously, the market has now priced in the successful implementation of the Trump policies that will help growth (tax cuts, infrastructure spending, deregulation) but none of the policies that will hurt it (protectionism, the greenback’s rise, increased deficits). For that reason, I think U.S. Treasuries are oversold based on the market’s current assumptions, and since Government of Canada (GoC) bond yields move in virtual lock-step with their U.S. equivalents, GoC bonds are currently oversold as well.
• “The U.S. dollar has continued to appreciate against most other advanced and emerging-market currencies, reaching its highest level in nearly 15 years on a nominal trade-weighted basis.” The rapidly appreciating U.S. dollar shows no signs of slowing down and the higher it goes, the harder it will be for U.S. exporters. This will make it harder for many Canadian exporters as well because, as CIBC economist Benjamin Tal recently observed, many of the products we sell into U.S. markets are tied to the production chain of U.S. exporters. Thus, if the demand for their exports falls, so too will the demand for ours.
• “Consumption growth is projected to remain healthy, supported by robust fundamentals, including a strong labour market with gradually rising wages. Business investment is expected to regain momentum as growth in demand remains above growth in potential output.” I disagree with this key BoC assumption. The strength of the U.S. labour market is still up for debate – it’s improving, but calling it “robust” seems like a stretch. More glaringly though, the Bank is expecting business investment to pick up as demand rises faster than output, but even if that happens, I think that businesses are worried about the same uncertainties as policy makers are, and that they will be reluctant to make significant investments in capacity expansion against the current backdrop. Also, our policy makers have been predicting an increase in business investment for some time now and it hasn’t happened, so this forecasting comes with a few heaping tablespoons of hope mixed in for good measure.

Canadian Commentary

• “Real GDP is expected to grow at a rate moderately above that of potential output throughout the projection horizon”. The BoC has raised its prior GDP forecasts for our economy from 1.1% to 1.3% in 2016, and from 2.0% to 2.1% in 2017. It predicts that “growth in the service sector in particular will underpin rising employment, household incomes and consumption”, but further on the Bank acknowledges that employment growth in the service sector has been mainly in part-time and lower-paying positions. It’s hard to see how this type of employment growth will underpin the rising incomes and consumption that the BoC is calling for.
• The Bank acknowledged that “export growth will be limited by the recent appreciation of the Canadian dollar, alongside that of the U.S. dollar, vis-à-vis most other currencies.” Because other currencies have lost more value than the loonie of late, the competitive boost we would normally get from its fall is essentially limited only to U.S. markets at a time when we would love to start selling more to the rest of the world. To address this challenge, the BoC would at least consider dropping its policy rate to weaken the loonie further (and in his post-meeting press conference, BoC Governor Poloz confirmed that a rate cut is still on the table if needed).
• The BoC expects that our growth will be “underpinned by solid household consumption and fiscal infrastructure spending.” A few tablespoons of hope are needed in that forecast as well when average wage growth is minimal and we have yet to see meaningful infrastructure spending kick in. (The benefits of infrastructure spending can take time to accrue.) Meanwhile, the Bank expects residential-mortgage investment “to contract further as resale activity is dampened by higher mortgage rates and the recent changes to federal housing finance policies”, while “growth in business investment and exports of non-energy goods will remain modest.” In other words, growth in real-estate related sectors, which has accounted for most of our incremental GDP growth of late, will slow, and it doesn’t look as though business investment and/or exports are poised to take up the slack.
• “National employment growth has remained firm over the past year, although it has been concentrated in part-time employment. Total hours worked have not risen and, in contrast to the United States, wage pressures continue to be subdued. Overall, the Bank’s labour market indicator suggests an increase in slack over the past year.” This increase in slack and the “material excess capacity” that accompanies it provide the latest confirmation that any BoC rate hikes are still likely to be a long way off.
• “[Fixed] mortgage interest rates have increased since October, mainly reflecting higher funding costs. As in October, the Bank estimates that the impact of the federal government’s tighter housing-related measures will subtract 0.3 per cent from the level of real GDP by the end of 2018.” That -0.30% understates the real impact of the latest mortgage rule changes though, because as mentioned above, until recently residential mortgage investment was a big, positive driver of Canadian GDP growth. I called the most recent mortgage rule changes short-term pain for long-term gain, and that -0.3% is the short-term pain part.
• “By around mid-2018, inflation is expected to be sustainably at the target as excess capacity in the economy dissipates.” This would be about the time that the Bank would be expected to raise its policy rate, but take this forecast with a healthy chunk of salt because the BoC has been forecasting policy-rate hikes just over the horizon since the start of the Great Recession in 2008  and those goal posts have been pushed out more times than I can count.

Five-year GoC bond yields rose by one basis point last week, closing at 1.13% on Friday. Five-year fixed-rate mortgages are available at rates anywhere from 2.59% to 2.94%, with rates at the lower end of that range offered on loans that are eligible for some form of default insurance, and rates at the higher end of that range offered on loans that are not eligible. (If you want to learn whether you and your loan are eligible for default insurance , check out Part One and Part Two of my recent posts on this topic.) Five-year fixed-rate pre-approvals are now offered at around 2.94%.

Five-year variable-rate mortgages are still available in the prime minus 0.35% to prime minus 0.60% range, which translates into rates of 2.25% to 2.10% using today’s prime rate of 2.70%.

The Bottom Line: When the theme of the latest MPR is uncertainty and the BoC references the “persistent competitiveness challenges” for our currency, “material excess capacity”, “increased labour-market slack”, “subdued wages pressures” and inflation that was “weaker than expected”, you shouldn’t be losing any sleep worrying that mortgage rates are going to rise in the foreseeable future. Of course, the uncertainty surrounding the Trump presidency might be keeping you up at night, but there’s not much the BoC can do to help with that.