In today’s post I offer my forecast for five-year variable rates in 2018. (FYI – You can read my forecast for five-year fixed rates here.)
Also, at the end of the post I offer my take on whether five-year fixed or variable rates are likely to offer the lowest cost over the next five years and, more importantly, my take on which is the better option for most borrowers in the current environment.
The Bank of Canada (BoC) raised its policy rate for the first time in more than seven years over the course of 2017, from 0.50% to 1.00%, and lender prime rates, which variable-rate mortgages are priced on, quickly followed.
At the time, the BoC explained that it was clawing back the two 0.25% emergency rate cuts that it had made in response to the global oil-price shock because it was satisfied that our economy had completed its adjustment to lower oil prices, and additional rate hikes did not seem imminent. But then inflationary pressures continued to build and by the time 2017 drew to a close, the BoC was once again sounding hawkish about near-term rate increases.
First off, I’d like to wish a very happy new year to my readers.
In today’s post I offer my forecast for five-year fixed rates in 2018, and next week, I’ll do the same for five-year variable rates.
Five-year fixed mortgage rates bottomed in the low 2% range in the first half of 2017 and by the end of the year they had climbed back up to around 3%. This marked the most significant proportional increase that we have seen in fixed rates since the start of the Great Recession.
In spite of that, a five-year fixed rate of 3% is still dirt cheap by any historical comparison and today the vast majority of Canadians can afford their mortgage payments. This reality is borne out by today’s overall mortgage default rate, which stands at its lowest level in decades.
But if rates continue to rise, affordability will deteriorate.
This year, in addition to thinking up soon-to-be-broken new year’s resolutions, many Canadians will be wondering, and worrying, about the impact that the next round of mortgage rule changes will have on our mortgage and housing markets as well as on our overall economic momentum.
Their concern is warranted.
The Office of the Superintendent of Financial Institutions (OSFI) is about to implement the most substantial mortgage rule changes to date. As of January 1, among other changes, conventional borrowers (who make down payments of 20% or more of the purchase price), will be required to qualify using a stress-test rate that is significantly higher than the actual rate they will be paying on their mortgage.
To put that in perspective, conventional borrowers make up about two-thirds of the total Canadian mortgage market. (You can read my detailed explanation of the coming rule changes here.)
In today’s post, in the spirit of another new year’s tradition, I’m going to poke my neck out further than usual and offer predictions on how I think the impacts from the coming mortgage rule changes will materialize in the new year. (Note: The only certainty with the following predictions is that when you combine them with $1.50 you can buy one cup of hot coffee.)
In its accompanying statement the Bank explained how developments both at home and abroad have influenced its overall economic view and today’s post will unpack this brief but detailed assessment by highlighting five key observations for anyone keeping an eye on Canadian mortgage rates:
Our pace of job creation matters to anyone keeping an eye on Canadian mortgage rates because over time, as the demand for labour increases, its cost should rise. And since labour costs are a significant component in the overall cost of most of the items and services that we buy, their relative movements can have a powerful impact on overall inflation (which can then lead to higher mortgage rates).
Bank of Canada (BoC) Governor Poloz recently stated his belief that our economy is hovering in what he calls an “inflationary sweet spot” where both our actual output and our maximum potential output are expanding. At the moment, this is giving our economy more room for non-inflationary growth, but a surge in employment demand could easily upset this delicate balance and compel the BoC to accelerate its rate-hike timetable.
The market’s reaction to the latest employment data was dramatic. Government of Canada (GoC) five-year bond yields surged higher by almost ten basis points, the Loonie registered its biggest one-day gain against the Greenback in almost two years, and the futures market increased the odds from 40% to 66% that the BoC will raise its policy rate in January.
On January 1, 2018, our regulators will implement a sixth round of mortgage rule changes as part of their ongoing attempts to slow our economy’s rate of mortgage debt accumulation. While I agree in principle with their instincts and with their earlier changes, I take issue with their most recent methodology.
For example, in a recent post I criticized the decision to use an average of the posted rates at the Big Six Banks to set the stress-test rate, because posted rates aren’t actually used for lending and because relying on rates from a sub-group of lenders effectively means that the regulator is delegating de facto control over consumer access to mainstream borrowing. I also questioned whether 4.99% was the right rate to use and called on our regulators to provide a more thorough rationale for their approach, basically arguing that the stress test should also be subject to a smell test, especially given its increased importance as a key Canadian benchmark rate.
While I think a deeper explanation is warranted in both cases, more pressingly, there are two specific aspects of the upcoming changes that are fundamentally flawed and need to be addressed prior to January 1.
Much of that data can seem quite technical at first glance, but the overall trends are easier to spot. For example, last week we learned that our overall inflation rate, as measured by the Consumer Price Index (CPI), fell from 1.6% in September to 1.4% in October. That’s at the bottom of the Bank of Canada’s (BoC) target band of 1% to 3%, and well below its official 2% target. Clearly, inflation still isn’t putting pressure on the Bank to raise its policy rate any time soon.
In a mortgage-rate context, that means that variable-rate borrowers aren’t likely to see their rates rise over the near term, as many pundits confidently predicted (and this blogger refuted) not long ago. At the same time, subdued inflation also takes pressure off Government of Canada (GoC) bond yields, which our fixed mortgage rates are priced on.
In today’s post, we’ll look at the latest inflation data, but before we do, we’ll examine recent BoC observations about current inflation and how the Bank is using monetary policy to manage inflationary risks through a period of heightened uncertainty. While the inflation data are important, the interpretation of that data by the BoC is arguably even more so.
As of January 1, 2018, everyone who borrows from a federally regulated mortgage lender must qualify using the Mortgage Qualifying Rate (MQR), except for renewing borrowers (who aren’t subject to this new standard if they stay with their existing lender).
The MQR, which is also commonly referred to as the ‘stress-test rate’, was designed to ensure that anyone taking on mortgage debt at today’s ultra-low rates can afford for them to rise in future (and using today’s MQR, that means all the way to 4.99%).
While this is a sound and prudent approach in theory, the method that is used to set the MQR is seriously flawed. And given the impact that this all-encompassing benchmark rate will soon have on the mortgage market, it should be modified ASAP.
In today’s post we’ll start by taking a look at how the MQR is currently set. Then we’ll use an example to contrast the MQR’s impact on a person’s ability to qualify today with the impact that actually borrowing at the MQR rate would have on that same person five years hence. Put simply, we’ll conduct a stress test for the stress-test rate.
Our economy added 35,300 new jobs last month and that was more than double the consensus forecast of 15,000 new jobs. The Loonie surged higher on the news and so did Government of Canada (GoC) bond yields as investors upped their bets that the Bank of Canada (BoC) would raise its policy rate once again in early 2018.
While this upside beat was a welcome surprise, our strong employment data in October stand in contrast to other recent data. For example, last week we also learned that our GDP growth fell by 0.1% in August on a month-over-month basis, after coming in at 0% in July, and our export sales revenue fell by 0.3% month-over-month in September. Our export sales have now dropped for four straight months by a total of 1.1% since hitting a record high in May as the headwind from the lofty Loonie continues to buffet our hard-won momentum in that sector.
Therein lies the challenge for the BoC.
The Bank of Canada (BoC) left its policy rate unchanged last week, as expected. The Bank also sounded more cautious about hiking rates in the near future, and that was somewhat unexpected (at least to market watchers who are not regular readers of this blog).
Uncertainty was the BoC’s key theme, around everything from inflation to wage growth to trade policy. To its credit the Bank was willing to admit that we have entered a period of heightened uncertainty, where its plans may change quickly in response to new data (unlike in the U.S., where the Federal Reserve sounds determined to raise rates regardless of whether the current U.S. economic data support additional increases).
The BoC’s announcement also included the release of its quarterly Monetary Policy Report (MPR), for October. The MPR provides us with the Bank’s latest assessment of the current economic conditions at home and abroad and includes forecasts of key economic data.
In today’s post I’ll provide the highlights from the latest MPR broken down between its international and domestic commentary, with my related comments under each bullet. Then I’ll close with a summary of the four main causes of uncertainty the Bank is now grappling with.
Last week the Office of the Superintendent of Financial Institutions (OSFI) announced three changes to its B-20 guidelines, which are otherwise known as the mortgage rules that must be used by all federally regulated lenders.
This sixth round of B-20 changes since the financial crisis in 2008 will take effect on January 1, 2018. If past is prologue, the changes will apply to new applications submitted on or after that date (and pre-approvals that are converted beyond January 1 will be subject to the new rules as well).
In today’s post I outline the latest changes and offer my take.
Today, if you offered central bankers from the world’s developed economies a 2% annual GDP growth rate, most of them would take it and run. Even China, whose GDP grew by an average of almost 10% over the thirty-year period from 1980 to 2010, saw its annual GDP growth rate slow to 6.7% in 2016, marking a 26-year low.
When Canadian GDP growth came it at 4.5% in the second quarter of this year, some market watchers speculated that this accelerating growth would fuel higher inflation, and that led them to forecast that the Bank of Canada (BoC) would hike rates multiple times over the next twelve months.
I have offered a different view in recent posts, making the case that our rates are likely to stay lower for longer, and I highlighted the surging Loonie as one of the key factors that will contribute to that outcome.
My thinking was that while a relatively weak Loonie provided our economy with a tailwind in Q2, its surge after the BoC’s two policy-rate rises this summer has since converted that tailwind into a headwind.
It was only natural to conclude that the soaring Loonie would crimp demand for our exports, and our most recent export data have confirmed that to be the case (exports having fallen more than 10% from their peak in May). But waning export demand isn’t even the most significant factor that will slow our economic momentum over the next twelve months.
Exports make up about 30% of our overall GDP, whereas consumer spending accounts for about 58% of it. So while our export sector has garnered a lot of recent attention for having finally awakened from its long slumber, we as consumers have a much bigger impact on our economy, and our spending has fuelled most of its momentum since 2008. (The chart below pretty well sums it up.)
We received the September Canadian employment report last Friday and while it showed that our rate of job creation slowed, it also confirmed that average wages increased by 2.2% on a year-over-year basis.
The average wage has been slow to rise over the past several years, even as our economy has created jobs at a robust rate. That hasn’t come as a total surprise because wage growth typically lags job growth, but the lag in our current cycle has persisted for longer than expected. This has led to speculation that other factors such as globalization, automation, and the increased prevalence of just-in-time manufacturing are conspiring to keep wages down.
With year-over-year average wage growth peeking its head over the 2% threshold for the first time since last June, investors are increasing their bets that the Bank of Canada (BoC) will raise its policy rate again before the end of this year.
The Bank has recently emphasized that it will be very data dependent when determining future monetary policy and accelerating wage growth raises the odds that it might raise rates pre-emptively to stave off a sharp acceleration in overall inflation (because labour costs have a big impact on the prices of most of what we buy).
Before I offer my take on what this latest development means for our near-term mortgage rates, let’s look at the other highlights from the September employment report:
Good News for Variable-Rate Mortgage Borrowers: Governor Poloz Shifts the Bank of Canada Into Neutral … For Now
These were his first public comments since the BoC began to raise its overnight rate in July. Market watchers have been debating whether the Bank would now pause, after reversing the two 0.25% rate cuts that it had made in 2015 in response to the oil-price shock, or continue to raise rates to mitigate against the risk of rising inflationary pressures over the medium term.
The answer to that key question has important implications for both fixed and variable mortgage rates.
If the BoC continues to raise its overnight rate, lender prime rates will move higher in lock step. And since variable-rate mortgages are priced on lender prime rates, additional policy-rate increases by the Bank will immediately translate into higher borrowing costs for variable-rate borrowers.
Fixed-rate mortgages are priced on Government of Canada (GoC) bond yields, and while those yields do not automatically move when the BoC raises its policy rate, they often respond to changes in the Bank’s outlook. This is especially true for longer-term GoC bonds because their extended duration makes them highly sensitive to even subtle changes in the BoC’s views on inflation and growth.
The title of Governor Poloz’s latest speech is “Data Dependence: Economic Progress Report” and that further piqued my interest because in several of my recent blog posts I have made the case that our key economic data should give the BoC pause before it hikes its policy rate further. (In those posts I explain why the surging Loonie, low inflation and sluggish wage growth all support a near term wait-and-see approach by the BoC.)
Here are the highlights from Governor Poloz’s speech last week:
Market watchers are currently engaged in a spirited debate about whether the Bank of Canada (BoC) will continue to raise its policy rate in the near future. In last week’s post I explained why the Loonie’s recent movements against a basket of other currencies make more near-term BoC rate rises unlikely. In today’s post we’ll take a detailed look at the latest inflation data, which I believe further bolsters that view.
When the BoC raised its overnight rate by 0.25% in each of July and September, it justified these increases by saying that it must “anticipate the road ahead”. The Bank believed that our improving economic momentum would lead to higher inflation. It wanted to raise its policy rate pre-emptively to help ensure that inflation didn’t accelerate to a degree that would require more severe (and economically disruptive) monetary-policy tightening farther down the road.
This forward-looking approach to inflation initially appears consistent with the BoC’s mandate “to conduct monetary policy to promote the economic and financial well-being of Canadians … by keeping inflation low, stable and predictable.” But the Bank’s mandate also requires that its inflation-targeting approach be “symmetric”, which, in the BoC’s words, “means that the Bank is equally concerned about inflation rising above or falling below the 2 per cent target”, and on that front, its actions belie its words.
Here is a graph of our overall inflation rate since the start of the Great Recession as measured by our Total Consumer Price Index (CPI):