Of course, today’s fixed mortgage rates don’t come with any guarantees that they will prove cheaper than variable rates over their full term. Let’s not forget that variable rates have outperformed fixed rates about 90% of the time over the past twenty-five years.
Those are some stacked odds to bet against.
But borrowers are used to receiving an upfront discount for taking on variable-rate risk, and when that’s not available, almost everyone opts for the stability of locked-in payments. (The savviest of these borrowers are also ensuring that their fixed-rate mortgages come with reasonable penalties, which allow them the flexibility to refinance if rates drop further, as I wrote in this recent post.)
What about existing variable-rate borrowers? Should they lock in a fixed rate now?
That means variable mortgage rates, which move in direct response to BoC policy-rate changes, will remain at their current levels for the time being. But the Bank’s increasingly cautious assessment of our economic landscape and focus on downside risks have the consensus now predicting that it will likely cut in the near future.
The BoC’s more dovish tone had an immediate impact on bond yields, and by association, our fixed mortgage rates.
The five-year Government of Canada (GoC) bond yield, which our five-year fixed mortgage rates are priced on, dropped by 0.15% shortly after the Bank’s latest announcement. If the GoC bond yield falls much farther, five-year fixed rates should move lower (subject to the old saw about lenders taking the elevator when they raise rates and the stairs when they lower them).
Here is a summary of my take on the BoC’s latest statement and its accompanying Monetary Policy Report (MPR), which is the Bank’s quarterly assessment of economic conditions both at home and abroad.
With that in mind, in today’s post I had initially planned to revisit the age-old fixed-versus-variable rate question, which is always a popular topic. But in the current environment where our bond-yield curve remains inverted and fixed rates are lower than variable rates, that question seems less compelling. Simply put, when borrowers aren’t receiving a discount to take on variable-rate risk, they just aren’t inclined to do it.
Today the vast majority of buyers are opting for a five-year fixed rate. In addition to having rates that are lower than equivalent variable rates, they are now also cheaper than almost all other fixed-rate terms.
While this current backdrop has simplified the range of options for borrowers, it has not levelled the playing field. Five-year fixed-rate mortgages are not created equal. To wit, in the current environment, mortgages that offer maximum flexibility have proven far more economical than alternatives that may be lower priced but are less flexible.
Here is an example that illustrates why flexibility is so valuable:
Investors, tired of the paltry returns in our low-interest-rate environment, have been selling off safe-haven assets, like U.S. Treasuries and Government of Canada (GoC) bonds, and shifting into riskier investments, like equities. The selling of these bonds causes their prices to fall and their yields, which our fixed mortgage rates are priced on, to rise.
Financial markets are ruled by either fear or greed. While greed has once again become the dominant sentiment, I believe this recent trend is based on misplaced optimism.
Last week’s market-moving news centred around the announcement of phase one of a U.S./China trade deal, but a closer look at the details leads me to conclude that any associated boost will likely be short lived.
Despite this, some market watchers speculate that the Bank of Canada (BoC) will delay cutting its policy rate for fear that it will fuel increased borrowing and accelerate house-price appreciation (which has picked up on its own lately).
This theory is fundamentally flawed for two reasons:
- A BoC rate cut only affects variable mortgage rates, and few borrowers are opting for variable rates in the current environment.
The Canadian yield curve is still inverted, meaning that short-term interest rates are higher than longer-term interest rates, and as such, just about everyone is opting for fixed rates now. Consider that today, the average five-year variable mortgage rate is priced about 0.50% higher than its five-year fixed-rate equivalent.
Given that gap, current variable rates won’t be remotely attractive to most borrowers at least until the BoC has made its third 0.25% cut from today’s levels. The vast majority of borrowers aren’t likely to take on variable-rate risk without receiving an initial discount to the available fixed-rate alternatives.
The U.S. economy is showing clear signs of slowing, and the bond futures market is now assigning a 76% probability that the U.S. Federal Reserve will cut its policy rate by another 0.25% when it next meets on October 30 and 70% odds that it will lower by another 0.25% when it meets on January 29.
The Fed’s actions matter to anyone keeping an eye on Canadian mortgage rates.
First, the policy rates at the Fed and the Bank of Canada (BoC) are basically now equal, and that increases the pressure for the BoC to match any additional Fed cuts (as I wrote about in detail in this recent post). If the BoC lowers, Canadian variable-rate borrowers would see their first rate drop in more than four years.
Secondly, the Fed’s actions have an indirect but significant impact on U.S. treasury yields, and Government of Canada (GoC) bond yields, which our fixed mortgage rates are priced on, usually move in lockstep with their U.S. equivalents. For the most recent example, check out the movements in the 5- year U.S. treasury and GoC bond yields over the past 30 days:
Given that, in today’s post I will turn my attention to a key issue for voters in our upcoming federal election: housing affordability.
Each political party is now offering solutions to address today’s affordability challenges, and last Tuesday I joined TV journalist Carole McNeil on CBC News for a Canada Votes segment that focused on different housing-policy issues and proposals (which you can watch here).
In today’s post, instead of evaluating everyone else’s ideas, I will offer my own view by highlighting five mortgage and real-estate-related changes that are most likely to improve housing affordability (without unduly increasing household debt levels in the bargain).
Last Wednesday the U.S. Federal Reserve cut its policy rate by another 0.25%, dropping it down to a range between 2.00% and 1.75%. In its accompanying statement, the Fed conveyed both optimism and caution.
Before we examine the Fed’s latest statement, let’s recap why the Fed’s actions matter to anyone keeping an eye on Canadian mortgage rates.
When the Bank of Canada (BoC) met on September 4, the Government of Canada (GoC) five-year bond yield stood at 1.12%, which marked a 52-week low.
At the end of that meeting the Bank surprised market watchers when it released a more bullish than expected policy statement, and since then, our bond yields have moved steadily higher. To wit, the five-year GoC bond yield closed at 1.51% last Friday after its sharpest five-day increase in well over a year.
While on first pass the cause and effect of our recent bond-yield surge may seem clear, a closer look suggests otherwise.
Last week the Bank of Canada (BoC) left its policy rate unchanged, at 1.75%, as the consensus expected, but it also surprised market watchers by maintaining policy-rate language that gave no hint of rate cuts to come.
Most analysts believed that the Bank would shift to a more dovish tone at last week’s meeting and pave the way for a rate drop later this year. Instead, the Bank assessed that its policy rate was still “appropriate” based on current conditions.
For my part, in the lead-up to this meeting I argued that the BoC should cut its policy rate now, and I reiterated that belief even after we learned that overall inflation rose to the Bank’s 2% target in July.
My conclusion, based on the Bank’s oft-stated goal to anticipate the road ahead, was that it should cut its policy rate as a precaution (because it takes time for policy-rate changes to impact our economic momentum). But the Bank decided not to cut, and it didn’t even adopt more dovish language as a milder form of monetary easing.
Today most of the developed world’s central banks worry about having too little inflation if they are lucky and outright deflation if they aren’t. (Central bankers worry about deflation, which is an outright decline in average prices, because their monetary policy tools are much better suited to tamp down inflation than to reignite it.)
Bond-market investors also see deflationary headwinds gathering, and that partly explains the recent breathtaking rise of global bonds with negative yields, which now total around $17 trillion (and counting).
Against that backdrop, the Bank of Canada (BoC) is in an enviable position.
There are now almost $17 trillion worth of bonds trading at negative yields, up $4 trillion this month alone.
(Note: anyone buying a bond with a negative yield and holding it to maturity will receive back less than they paid for it.)
Here are some other examples of the “interesting times” in which we live:
At its last meeting, in July, the Bank assessed that the Canadian and U.S. economic trajectories were converging. Canadian economic momentum was recovering after a slump, and U.S. economic momentum was slowing after a period of above-potential growth. Against that backdrop, the BoC argued, divergent monetary-policy actions were justified.
It is also true that the Fed raised its policy rate by a quarter point nine times during its most recent tightening cycle while the BoC hiked only five times. Even after the Fed’s most recent cut, its policy rate still operates in a range that is 0.25% to 0.50% higher than the BoC’s policy rate.
In that context, I agree that the BoC shouldn’t run out to match the Fed’s next move as long as the Loonie isn’t soaring against the Greenback (which right now, it isn’t). But the Bank has other reasons to cut its policy rate at its next meeting, regardless of what the Fed is doing.
The Fed also announced that it would end its balance-sheet reduction program two months sooner than expected (which is another kind of monetary-policy easing).
Interestingly, financial markets did not respond to this news as expected.
When the Fed lowers its policy rate, borrowing costs fall and this usually stimulates economic growth. Investors normally respond by increasing their holdings in cyclically sensitive assets, like stocks and commodities, and by reducing their exposure to the U.S. dollar (which would be expected to weaken in relation to other currencies).
This time around, in each case, the opposite happened. In the immediate aftermath, equity and commodity prices fell and the Greenback rose.
Put another way, financial markets responded to the Fed as if it had actually raised its policy rate last week. Why?
Consider that today more than 13 trillion USD worth of bonds, mostly from Europe and Japan, trade at negative yields. (When a bond has a negative yield, it means that investors end up with less than they started with by the end of the term.)
The obvious question that follows is why anyone would buy a bond with a negative yield.
Simply put, the market is always governed by either fear or greed. When fear is winning out, as in the case of the bond market today, the safe return of capital takes priority over the return on capital.
Here are five fears that are driving investors into negative bond yields: