In last week’s post I made the case for five-year variable rates over their fixed-rate equivalents, based on my current view of where our economy is headed.
Today, I’ll simulate three different scenarios for variable rates over the next five years – one where the variable rate saves you money, one where fixed and variable rates break even, and another where the fixed rate wins out. You can then decide for yourself which rate path seems most likely for the years ahead.
Let’s start with a quick outline of the assumptions that I used to run the numbers:
- Purchase price: $600,000
- Mortgage amount: $480,000
- Amortization period: 25 years
- Five-year variable rate: 2.45% (today’s prime rate minus 1.00%)
- Initial variable-rate monthly payment: $2,138
- Five-year fixed rate: 3.39%
- Fixed-rate monthly payment: $2,369
In each simulation we’ll compare the total interest cost of the fixed and variable-rate options, with one additional wrinkle.
Five-year fixed-mortgage rates continued their upward march last week as the five-year Government of Canada (GoC) bond yield they are priced on hit its highest level in seven years. Meanwhile, five-year variable-rate discounts deepened, further widening the gap between five-year fixed and variable rates.
Over the past few years my advice has generally favoured five-year fixed over five-year variable rates. Not because I thought that variable rates were going to the moon as some pundits have unendingly warned, but because the gap between fixed and variable rates was small enough that the cost of uncertainty outweighed the potential reward for most borrowers.
Today, the inherent uncertainty in variable rates remains, but its increased potential saving may now be worth the risk. (Five-year variable rates have offered a discount of about 0.50% when compared with their fixed-rate equivalents over the past several years, and that discount has now widened to 0.75% or more.)
My view isn’t based just on the fact that the fixed/variable rate-gap is widening. It is also underpinned by the different ways that the bond market and the Bank of Canada (BoC) are responding to the current rise in inflationary pressures.
There is no new post this week but I will be back up and running next Monday as usual.
In the meantime, here are links to my five most popular posts thus far in 2018:
Last week TD Canada Trust raised its five-year posted rate from 5.14% to 5.59%, and shortly thereafter, Royal Bank and National Bank increased their five-year posted rates from 5.14% to 5.34%. Other major banks are expected to follow shortly.
At first glance these increases may seem innocuous to mortgage borrowers because bank posted rates are not typically used for lending. (For comparison, today’s actual market five-year fixed rates are offered in the low to mid-three percent range.) But the posted rates from the Big Six banks are now used by our regulators to determine how much we can borrow, and as their importance grows, their use should be subject to more scrutiny.
Although posted rates have been around for a long time, they are somewhat mysterious because borrowers don’t pay them and these rates don’t move consistently in response to market forces. With nothing to anchor them, they can be moved up or down arbitrarily at each bank’s whim.
The Bank of Canada (BoC) left its overnight rate unchanged last week, as most market watchers expected. The Bank also released its latest quarterly Monetary Policy Report (MPR), which provides us with the Bank’s assessment of the current economic conditions at home and abroad and includes forecasts for key economic data.
The overall tone of the BoC’s latest MPR sounded cautiously optimistic – cautious over the short term but more optimistic over the longer term. Bluntly put, I think the Bank’s latest assessment makes it less likely to raise rates in the near term, but also reconfirms its belief that a rate hike will eventually be its next move.
In last week’s post I outlined five key questions for the BoC’s latest meeting and in this week’s post, I answer them using highlights from the Bank’s latest policy statement and MPR (with my accompanying comments in italics).
The Bank of Canada (BoC) meets this Wednesday, and while most market watchers aren’t expecting the Bank to raise its overnight rate at this meeting there is still the possibility that its accompanying commentary could push Government of Canada (GoC) bond yields higher, along with the fixed mortgage rates that are priced on them.
The BoC will also release its latest quarterly Monetary Policy Report (MPR). The MPR provides us with the Bank’s latest assessment of the current economic conditions at home and abroad and includes forecasts for key economic data.
Simply put, if you’re trying to figure out where fixed and variable mortgage rates may be headed, Wednesday will be an important day.
With that in mind, here are five key questions that I’ll be looking for the BoC to answer:
What the Canadian Bond Market’s Surprising Reaction to Last Week’s Employment Data Means for Our Mortgage Rates
While the headline result came as a surprise, the much bigger surprise, at least to me, was the bond market’s reaction.
Over the past year, bond-market investors have become increasingly confident that our job market’s momentum will compel the Bank of Canada (BoC) to raise its overnight rate. This view was maintained even after our economy lost 88,000 jobs in January, reversing much of the late surge that we saw at the end of 2017. Only two weeks ago our bond futures market was assigning an 80% probability that the BoC would raise its policy rate in May, despite cautious recent commentary from the Bank itself.
Against that backdrop, when I read that our economy added 32,300 new jobs last month, I expected to see the five-year Government of Canada (GoC) bond yield surging higher in response. But when I clicked over to check, it wasn’t following suit.
To my surprise, the five-year GoC bond yield closed lower for the day on Friday, and at the same time the bond-futures market had dropped the probability of a BoC rate rise in May to 40%.
What had caused bond-market investors, who are known to shoot first and ask questions later, to react bearishly to such a bullish headline?
Last week, Statistics Canada confirmed that our economic momentum slowed sharply in January as our GDP fell by 0.1% over the month. The drop was primarily attributed to sharp decreases in oil production and real-estate activity.
While our January result came in below the consensus forecast of 0.1% increase, some loss in momentum was largely expected.
Our policy makers are trying to slow our economy’s rate of household debt accumulation and as that happens, consumer spending, which comprises about 58% of our overall GDP, is bound to decrease. Their hope is that business investment, which accounts for about 20% of our GDP, and exports, which account for about 27% of our GDP, will take up the slack.
On that note, our manufacturing output surged higher by 0.7% in January and served as the only bright spot last month. That impressive uptick marks the third time in the last four months that our manufacturing output has increased and that bodes well for both exports and business investment if it is sustained. But will it be?
Why I Don’t Think The Bank of Canada Will Over-React to the Latest Inflation Data (As the Bond Market Did)
Last week Statistics Canada confirmed that year-over-year overall inflation spiked from 1.7% in January to 2.2% in February. At the same time, two of the three gauges that the Bank of Canada (BoC) uses to measure core inflation also breached the Bank’s 2% target threshold last month.
Bond-market investors reacted quickly to the higher-than-expected inflation readings and increased the odds that the BoC would raise its policy rate from 67% to 80% when it meets in May.
There is no arguing that Canada’s inflation measures are running hot at the moment, but I think this was an over-reaction. I continue to believe that the BoC will prove to be much more cautious than bond-market investors, and many mainstream economists currently expect.
When the BoC met earlier this month, in its accompanying policy-rate commentary, it anticipated that inflation would spike over the short term, and it attributed this rise to “temporary factors” that would dissipate over time. The Bank also reiterated its confidence that inflation would “remain close to 2% over the projected horizon”.
While there is no question that the BoC is keeping an eye on rising inflationary pressures, other recent economic data indicate that these pressures may ease on their own in the near future without additional BoC hikes.
The only real question leading up to this meeting centred on the tone of the Bank’s accompanying statement. Would the BoC convey a hawkish bias out of concern for rising inflationary pressures and tightening labour market conditions, or would it sound more cautious in deference to increased trade uncertainty and the lagging effects of the three rate hikes it had recently made?
The answer to that question matters to anyone keeping an eye on Canadian mortgage rates because when the Bank increases its overnight rate, our variable mortgage rates rise in lock step. Meanwhile, our fixed mortgage rates are priced on Government of Canada (GoC) bond yields and they often fluctuate in response to changes in the BoC’s tone, even if no rate hike actually occurs.
In the lead up to this meeting, our mainstream economist consensus forecast called for two more BoC rate hikes this year (down from three at the start of the year). Regular readers of this blog will recall that I disagreed with that forecast and made the case that the Bank would prove much more cautious for the following five reasons:
Last Thursday, seemingly out of the blue, President Trump announced that the U.S. would impose a 25% tariff on imported steel and a 10% tariff on imported aluminum, adding that these new taxes may be applied as early as this week.
The U.S. President has a surprising amount of latitude on trade policy. In this case, Trump is arguing that the U.S. steel and aluminum industries are strategically important to the U.S. military. In theory, if foreign competition is allowed to starve out domestic production by dumping cheap steel and aluminum into U.S. markets, the U.S. industrial base may be degraded to the point where it cannot adequately supply the U.S. military in times of war.
Interestingly, the U.S. Department of Defense (DoD) quickly responded to Trump’s announcement by saying that “DoD does not believe that the findings in the reports [of harm to domestic steel and aluminum producers from foreign competition] impact the ability of DoD programs to acquire the steel or aluminum necessary to meet national defense requirements.” Furthermore, the DoD has expressed concern that the newly announced tariffs may do more harm than good to U.S. national security because they risk damaging relationships with long-standing U.S. allies.
Also, by increasing their costs, the tariffs will make many other U.S. industries more vulnerable to foreign competition.
While President Trump used national security concerns to justify the new tariffs, it is widely agreed that his real motivation was to throw protectionist red meat to his political base. Strangely though, while he has tended to focus on China when railing against unfair trade practices, the new tariffs will have a much more significant impact on its allies, including Canada and the EU.
This is where President Trump’s decision becomes increasingly confounding.
This debate should be of interest to both fixed and variable-rate mortgage borrowers because bank prime rates, which our variable-rate mortgages are priced on, move in lockstep with the Bank’s overnight rate, and our fixed mortgage rates typically rise in anticipation of additional overnight rate increases.
Overall inflation, as measured by the Consumer Price Index (CPI), came in at 1.7%. This was higher than the consensus forecast of 1.4% – but a decrease from 1.9% in December.
The consensus read of the latest inflation data, which showed only a modest uptick of one of the BoC’s key sub-measures of inflation (more on that below), was that this slight change is not likely to alter the Bank’s plan to raise its overnight rate at some point this summer. I continue to disagree with this view and believe that the Bank will once again prove more cautious than our mainstream economists are forecasting.
Why the Bank of Canada Will Be Cautious in 2018 (And It Isn’t Just Because of the January Employment Data)
Our economy lost 88,000 jobs in January and that marked our biggest one-month drop in nine years.
Investors reacted quickly, driving Government of Canada (GoC) bond yields lower on Friday and decreasing the odds of a Bank of Canada (BoC) rate hike in April from 58% to 50% (which is still way too high in my opinion, but more about that later).
The BoC has said that it will be heavily data dependent when determining its future monetary-policy path. If the latest employment report is an early signal that our surging employment momentum is now abating, this means that the Bank will delay additional rate rises.
As always, however, the market shoots first and asks questions later. It is worth remembering that Statistics Canada’s employment data are estimates that come with significant margins of error (to both the upside and downside). Bluntly put, the latest employment data, bad as they seemed, were not a game changer and the BoC isn’t going to blow up its existing plans over one lousy jobs report.
Here are the highlights, or in this case, the lowlights, from the January employment data:
Bond-market bears have been looking for signs that U.S. inflationary pressures are building and the latest employment data fuelled speculation that U.S. labour costs may finally be breaking out.
The five-year Government of Canada (GoC) bond yield rose in sympathy with its U.S. counterpart and if that upward momentum carries over into this week, we will see another round of increases to our five-year fixed mortgage rates.
Here are the highlights from the latest U.S. employment data that got the market’s attention:
The consensus continues to believe that the Bank of Canada (BoC) will raise its policy rate by another 0.50% to 0.75% in 2018 but for the reasons I outlined in last week’s post, I think that is unlikely.
(Long story short, I think the BoC wants to allow time for its three recent policy-rate hikes and the most recent mortgage rule changes to work their way into our economy. At the same time, the Bank doesn’t want to push the soaring Loonie any higher and doesn’t want to slow our economic momentum by too much when there is considerable uncertainty about the ongoing NAFTA negotiations.)
While there has been a lot written about the BoC’s expected policy-rate path in the year ahead, there has been very little coverage of another development that has the potential to have an even more significant impact on Canadian mortgage rates in 2018.
After years of monetary-policy interventions on an unprecedented scale, recent central bank actions make it likely that this will be the first year since the start of the Great Recession in 2008 that global liquidity is reduced.
To explain how and why this will impact our mortgage rates, let’s start with a brief review of our recent past.