Government of Canada bond yields, which our fixed mortgage rates are priced on, edged a little higher, but five-year fixed rates continued to fall among laggard lenders who had not already lowered to match RBC’s recent cut.
Last Friday we received our latest inflation data, and while it showed an uptick in our overall Consumer Price Index (CPI), from 1.7% in November to 2.0% in December, most of that bump was caused by a spike in the cost of airfares and fresh vegetables. That isn’t likely to cause much concern at the Bank of Canada because its three key measures of core inflation, which strip out the inputs that cause short-term volatility in overall CPI, all held steady at 1.9%.
The Bottom Line: Five-year fixed rates continue to settle in at slightly lower levels and five-year variable rates are holding steady. Hopefully the U.S. federal government shutdown ends soon so the 800,000 affected U.S. workers can receive their back pay and market watchers can get an updated look at how the U.S. economy is faring at what appears to be a critical turning point in the U.S. business cycle.
The Bank also released its latest Monetary Policy Report (MPR), which provides a detailed analysis of where it sees both foreign and domestic economic growth and inflation headed over the next two years.
The latest MPR is of particular interest to market watchers because it is the first one issued since the BoC shifted from hawkish to dovish policy-rate language in December (its previous MPR was released last October).
In summary, the Bank expects our current slowdown to continue through the first half of 2019 before our economy resumes its previous growth trajectory. Its latest forecast is based on the assumption that our economic momentum will be supported by “strong employment, expanding foreign demand and accommodative financial conditions”. In my view, there was a glaring omission in the Bank’s analysis, but before I get to that, let’s start with a quick summary of the highlights from the latest MPR.
At the start of 2018, forecasters focussed on the theme of synchronized global growth as signs of accelerating economic momentum abounded.
But that momentum did not prove self-reinforcing, as was hoped.
Instead, the stimulative impact from the much ballyhooed U.S. federal government tax cuts was short lived. Chinese economic growth slowed sharply as soon as new debt issuance was curtailed. While the eurozone has showed signs of life, it remains under constant threat, with Brexit and a potential Italian banking crisis now on the front burners. Oil prices have collapsed, and trade wars have cast a pall over everything.
Not surprisingly, forecasters ushered in 2019 with much more bearish projections, and many now predict that the second longest economic expansion in U.S. history will end in the near future. Main Street appears to concur with Wall Street’s less sanguine view – Google searches for the term “recession” are more than three times higher today than they were a year ago.
This has all happened quickly.
The U.S. Federal Reserve is widely expected to hike its policy rate by another 0.25% when it meets this Wednesday. The question that is being actively debated is whether it will also adopt more dovish language in its forward guidance (and the answer could impact Canadian mortgage rates).
The consensus expects (and hopes) that it will.
U.S. equity markets have taken a pounding of late (the S&P 500 Index has dropped by 12% since its 2018 peak on September 21). A growing number of market watchers are forecasting slowing U.S. economic momentum in 2019, and recession fears are rising. Those fears are evident in the spread between 2-year and 10-year U.S. treasury rates, which has now narrowed to almost zero. If that spread goes negative, history says that a U.S. recession will more than likely follow (see chart).
To recap, when the Bank of Canada (BoC) met in October, it raised its policy rate by another 0.25% and declared that our economy was operating at its full capacity. The Bank warned that it would need to increase rates by another .75% to 1.75% in order to keep inflation near its 2% target, and it removed the reassurance that it would apply “a gradual approach” to additional hikes from its policy statement.
Not surprisingly, the consensus warned that mortgage rates were about to move materially higher.
I was more sceptical. In the post I wrote at that time, I argued that if the BoC was really going to be “guided by the incoming data”, then it seemed unlikely that a steady string of additional policy-rate rises was just around the corner. Our economic data were mixed at best and, since then, inflation has further moderated, oil prices have collapsed, average wage growth has continued to fall, and our GDP growth has slowed. (At the same time, trade tensions and instability risks beyond our borders have also intensified.)
Nobody said that the BoC’s job was easy, especially today.
On October 24 the Bank of Canada (BoC) hiked its overnight rate by another 0.25% and warned that additional increases were likely.
BoC Governor Poloz assessed that our policy rate of 1.75% remained “stimulative” and that it would need to rise to between 2.5% and 3.5% in order to keep inflation close to the Bank’s 2.0% target. Both he and BoC Deputy Governor Wilkins sounded upbeat about our economic momentum, and they expressed confidence in our economy’s ability to handle additional rate hikes.
Variable-rate mortgage borrowers grew increasingly nervous. Who could blame them?
After seven years without a single rate increase, they had just seen their fifth quarter-point hike in the last seventeen months, and the person with his hand on our policy-rate lever was warning that there were more to come.
I had my doubts, which I first outlined in this post asking “How Much Higher Will Canadian Mortgage Rates Go?”. In it, I outlined recent Canadian and U.S. economic data that showed signs of slowing momentum and highlighted the BoC’s own forecasts, which projected reduced economic growth rates for the global economy, the U.S., China and Canada over the next three years.
Then oil prices went from falling to free-falling. Worse still, the price gap between a barrel of Western Canadian Select (WCS) and a barrel of West Texas Intermediate (WTI) continued to widen, reaching a staggering 50 USD (a record), and that exacerbated the impact of the oil-price collapse on the Alberta oil patch.
On the one hand, the Bank may believe that it needs to raise its policy rate pre-emptively to stay out in front of rising inflationary pressures, but on the other hand, if our economic momentum has already begun to slow naturally, incremental rate hikes risk doing more harm than good.
Last week BoC Deputy Governor Carolyn Wilkins gave a speech about how the Bank’s monetary policy framework is evolving. In the Q & A session afterward she commented that the BoC may end up being a victim of its own success because if its policy-rate rises keep inflationary pressures contained, observers might say that the Bank’s monetary-policy tightening was unnecessary.
What she didn’t say is that in such a circumstance, because some of our economic momentum will need to be sacrificed at the altar of price stability, criticism may still be warranted. After all, over-tightening monetary policy also controls inflation, but at too high a cost.
I see that as the BoC’s biggest risk in the current environment.
Most market watchers now argue that fixed is the way to go in the current environment.
That view is based in large part on the latest policy-rate statement from the Bank of Canada (BoC), wherein it assessed that “the policy interest rate will need to rise to a neutral stance to achieve the inflation target”.
In plain English, the Bank essentially said that it expects it will need to raise our current policy rate of 1.75% into a neutral-rate range of between 2.5% and 3.5% in order to keep inflation at or very near 2%. (As a reminder, the neutral rate is defined as the BoC’s policy-rate level that neither stimulates nor restrains our economic growth.)
Variable mortgage rates are priced on the policy-rate, so if the Bank hikes by another 1% to 2%, our variable rates will increase by the same amount.
Given that five-year variable rates are only about 0.5% lower than their fixed-rate equivalents in the current environment, it might seem like a no brainer to choose fixed. But at times like this, the contrarian in me remembers the famous quote from legendary investor Bob Farrell who said: “When all the experts and forecasts agree — something else is going to happen”.
With that in mind, here is why the five-year variable rate may still be worth a look in the current environment.
The Bank of Canada (BoC) recently warned that higher interest rates will likely be required to keep inflation near to its 2% target. That view, however, is underpinned by what many consider to be an optimistic assessment of our current economic trajectory.
The Bank is predicting that accelerated business investment, increased demand for labour and resilient consumer spending will push our economy closer to its maximum capacity and fuel rising inflationary pressures. That said, the BoC also insists that it will be guided by the incoming data, and if that’s true, one wonders what data it is seeing that so many others, myself included, are missing.
BoC Governor Poloz assessed that our current policy rate of 1.75% “remains stimulative” and that it will need to rise to between 2.5% and 3.5% in order to keep inflation close to 2.0% (which I detailed in last week’s post). Both he and BoC Deputy Governor Wilkins sounded upbeat about our current economic momentum, and they expressed confidence in our economy’s ability to handle additional rate hikes.
While Governor Poloz restated that the Bank would be guided by the incoming data and would not operate on a predetermined path, he left little doubt that the BoC expects to keep raising rates over the near term. Interestingly, the data may test the veracity of that claim in short order.
Last week the Bank of Canada (BoC) raised its overnight rate by 0.25%, as was widely expected, and that means that variable mortgage rates (and line-of-credit rates) will increase by the same amount in short order.
What really caught the market’s attention was the Bank’s decision to drop the word “gradual” from its policy statement.
Instead of reiterating that it would take “a gradual approach, guided by incoming data”, as it has for some time now, the BoC instead cautioned that “the policy interest rate will need to rise to a neutral stance to achieve the inflation target”.
Let’s unpack that key phrase by first reviewing some terminology:
The Bank of Canada (BoC) is widely expected to increase its overnight rate by another 0.25% when it meets this Wednesday, and if that happens, variable-rate and home-equity line-of-credit (HELOC) borrowers will see their rates rise by the same amount shortly thereafter.
While fixed-rate mortgages will not be directly impacted by the BoC’s looming policy-rate hike, its accompanying commentary and the release of its latest Monetary Policy Report (MPR) may also push Government of Canada (GoC) bond yields higher, which our fixed mortgage rates are priced on. Most market watchers expect the BoC to sound a more upbeat tone on our economy this week for the following reasons:
- Our trade uncertainty clouds have finally parted. NAFTA has been replaced with the USMCA, and our policy maker’s worst fears of an escalating tariff war with our largest export partner can now be put to rest (subject to each member country approving the new agreement).
- Our economy grew faster than expected in the second quarter. In its July MPR, the Bank projected annualized second quarter GDP growth at 1.9%, but our actual result came in much higher, at 2.9%.
- Canadian businesses are upbeat. The BoC’s latest quarterly Business Outlook Survey, which was completed just before the USMCA was signed, showed that Canadian businesses were optimistic about future sales and already inclined to invest in productivity enhancements and expansion. That is encouraging because the BoC is hoping that business investment and rising export sales will replace consumer spending as the main drivers of our economic momentum.
- CIBC Chief Economist Avery Shenfeld recently noted that the BoC is likely “to sound sufficiently hawkish to justify the pain that rate hikes impose on debtors”. Essentially, the Bank’s words need to back up its actions.
All that said, the bond market’s reaction may well boil down to the inclusion or exclusion of the key word “gradual”.
For better or worse, our economy is deeply linked with the U.S. economy, and while that means that strong U.S. economic growth is currently helping to fuel momentum here at home, it also means that rising U.S. inflationary pressures, if sustained, will work their way north of the border through our extensive trading relationship.
That will likely cause the Bank of Canada (BoC) to raise its policy rate, which our variable mortgage rates are priced on, more quickly than it would otherwise. At the same time, bond-market investors will bid up Government of Canada (GoC) bond yields, which our fixed mortgage rates are priced on, in anticipation of that outcome.
With that in mind, let’s look at the most recent U.S. and Canadian growth and inflation data.
Fixed mortgage rates rose again last week as Government of Canada (GoC) bond yields continued to march higher, with most lenders increasing their five-year fixed-mortgage rates between 0.10% and .15%.
The main catalyst was the recent resolution of the NAFTA renegotiations, which lifted a cloud of uncertainty that had been hanging over the Canadian economy for the past thirteen months.
The new deal, called the United States-Mexico-Canada Agreement (USMCA), included several tweaks to the previous North American Free Trade Agreement (NAFTA), but none of them are likely to have a substantial impact on our economy. The real victory was simply that Canada would be included in this new “NAFTA 2.0” agreement and that U.S. President Trump’s most ominous threats, like slapping a 25% tariff on Canadian automotive imports, would not be realized.
Here are the key details in the new USMCA:
The Fed’s policy-rate movements are noteworthy to Canadians because our two economies are so deeply integrated and because the U.S. economy is about nine times bigger than ours. The Fed moves rates in response to changing U.S. economic conditions, and given that the Canadian economy tends to track the U.S. economy over time, the Fed’s actions can act as a bellwether for anyone keeping an eye on Canadian mortgage rates.
To that end, here are the key highlights from last week’s Fed meeting:
- The Fed’s policy-rate range was raised from 2.00% to 2.25%. (For context, the BoC’s policy rate currently stands at 1.5%.)
- The Fed raised its forecasts for U.S. GDP growth from 2.8% to 3.1% for 2018, and from 2.4% to 2.5% for 2019. Its previous estimate for GDP growth in 2020 was left unchanged at 2.0%.
- The Fed observed that “the labour market has continued to strengthen and that the economy has been rising at a strong rate”. The Fed also expressed confidence that U.S. inflation would continue to hover in the 2% range and said that it did not yet see evidence that recently enacted trade tariffs have impacted prices.
- The Fed’s most noteworthy change was the removal of the word “accommodative” when describing its current monetary policy stance in its press statement. Market watchers interpreted this as a sign that the Fed would slow the pace of its rate hikes, but U.S. Fed Chairman Jerome Powell subsequently clarified that the wording change was merely an acknowledgement “that policy is proceeding in line with our expectations”.
- The Fed is forecasting that it will raise its rate by another 0.25% when it meets in December, three more times throughout 2019, and then once more in 2020. (Interestingly, and by way of contrast, the futures market is pricing in only two more Fed rate hikes between now and the end of 2019.)
Now let’s draw out some implications for the Canadian economy and our mortgage rates: