Five Factors That Will Drive Canadian Mortgage Rates in 2016

In today’s post I’ll outline the five key factors that I think will most likely determine the path of Canadian mortgage rates in 2016.

Before we do that though, let’s revisit the post I wrote on the same topic at the start of the 2015 to see how those factors have played out over the last twelve months.

Recap of the Five Factors That I Predicted Would Drive Canadian Mortgage Rates in 2015

1. The strength of the U.S. economic recovery – The U.S. recovery eventually found a more solid footing in 2015, and as predicted, the Fed’s December rate rise did pull Canadian bond yields higher in sympathy. That said, because the first U.S. rate rise happened so late in the year, the impacts of the Fed’s first monetary-policy tightening in almost a decade have yet to be fully felt.
2. Slowing growth in China – Slowing growth in China did put downward pressure on commodity prices. The knock-on effects for our economic momentum were mostly negative, and as expected, China’s slowing growth did indirectly exert downward pressure on our mortgage rates.
3. The continuation of large-scale quantitative easing (QE) programs – The European Central Bank (ECB) finally backed up its words with action and launched QE programs in early 2015, and Japan also expanded its use of QE (again) last year. While China has not officially engaged in QE, it has adopted QE-type policies, for example, by making it easier for their commercial banks to lend more aggressively. China has also continued cutting interest rates, which it still has room to do because its benchmark one-year lending rate sits at a relatively lofty 4.35% today. That said, if China’s growth continues to slow and the country experiences turbulence as it transitions from an export-led to domestic-consumer-led economy, it’s not hard to imagine China adopting full-blown QE if needed. In summary then, the continued wide-scale use of QE and QE-type monetary-policy initiatives exerted downward pressure on global bond yields, as expected, and these developments helped keep Canadian mortgage rates at ultra-low levels.
4. The price of oil – Lower oil prices exerted downward pressure on our mortgage rates and their sharp fall dealt a body blow to our economic recovery. This made the Bank of Canada (BoC) increasingly cautious, which was expected, and led to two cuts to the BoC’s overnight rate, which was mostly unexpected.
5. The potential for the next financial crisis – The global economy made it through the last twelve months without experiencing a significant financial crisis, but the worry list of the potential risks to global economic stability is still a long one. More on that for this year below.

Not surprisingly, there is some overlap between last year’s key factors and those that will be most important heading into 2016. Here is this year’s list:

1. The strength of the U.S. recovery – When you export about three quarters of what you sell abroad to one country, your economic momentum will always be tied to theirs. The challenge for Canada today is that our economy seems more highly correlated with negative U.S. economic shocks, which we feel almost immediately, and not nearly as highly correlated to positive changes in U.S. economic momentum. This is in part because other countries that export to the U.S., like Mexico, have become more competitive and are taking share away from Canadian exporters, and also because our export sector is still in the process of reinventing itself after having been decimated in the initial years following the Great Recession. Against this backdrop, the impact of the relatively cheaper Loonie is muted because our current export-sector challenges are more structural than cyclical. That said, if the U.S. economy continues to gain momentum, it will give our economy a tailwind that will grow in strength as our export sector re-emerges from the ashes of its former self. But this will take time and I think that the BoC will continue its cautious monetary-policy approach in the interim, which should help keep a lid on our mortgage rates in 2016.
2. Commodity prices – Our economic momentum is also highly correlated with the direction of commodity prices, and most especially, the price of oil. When oil hovered in the $100/barrel range, it gave our economy a big boost in the initial years following the Great Recession, and the oil industry and its related sectors drove the majority of our employment growth and business investment over that period. In the new era of oil in the $40/barrel range, and falling commodity prices generally, our economy must now find new sources of momentum. This is easier said than done, as noted in my comments about the slow pace of our export-manufacturing recovery in the paragraph above. If commodity prices stay at today’s levels or fall further, I expect that the BoC will keep its monetary policy at today’s ultra-accommodative levels while it waits for new sources of positive economic growth to emerge.
3. Global instability – When global instability risks rise, everyone becomes more cautious. Our policy makers are reluctant to tighten monetary policy when instability risks are heightened, and investors undertake a flight to safety as the return of their capital becomes more important that the return on their capital. Both of these developments help keep our mortgage rates from rising (although many would trade this silver lining in exchange for clearer economic skies). I think the biggest threat to global stability in 2016 will come from the euro zone, which is grappling with a crisis that the ECB can’t print its way out of this time. Specifically, the euro zone is now being undermined by disagreement between its member countries on the handling of the Syrian-refugee crisis. The political cost of ceding control of each euro-zone country’s monetary and fiscal policies to Brussels was already high, and the added cost of allowing Brussels to meddle with each member country’s immigration policy will test the courage of incumbent politicians across the region and embolden the nationalist parties that seek to replace them.
4. Inflation – Inflation has been benign for so long that it may be hard for some people to imagine that a central bank would have to raise its policy rate to control it, but we are seeing costs rise in some key areas. For example, U.S. and Canadian labour costs outpaced overall inflation in their respective countries in 2015. Rising labour costs have been offset by other factors, such as lower commodity prices – but commodity prices aren’t expected to fall much further and labour cost inflation is typically stickier, which means that the upward pressure on inflation could prove more persistent throughout the coming year. While I don’t think that we’ll see significantly higher U.S. and Canadian inflation rates in 2016, if we do, this development alone could force the Fed and/or the BoC to raise rates to maintain price stability. For that reason, inflation is an important factor to watch for anyone keeping an eye on Canadian mortgage rates, even in its largely subdued current state.
5. The value of the Canadian dollar – The Loonie has fallen by nearly 30% against the Greenback over the past two years, and while a cheaper Loonie is widely credited with making our exports more competitive, this doesn’t provide the full picture. For example, our exporters often import materials, which they use to manufacture their products. When the Loonie falls, it means that these companies must absorb higher costs first, before hoping to recover them in the form of increased sales later. Furthermore, while our economy can adjust to changes in the value of the Loonie over time, a 30% drop over two years is a significant move and if the Loonie continues to depreciate, it could create a destabilizing effect. If that happens, the easiest way to reverse the Loonie’s momentum is for the BoC to raise its policy rate, and while that seems highly unlikely given that the Bank supports the Loonie’s current downward path (despite its claims of indifference), at some point it may not have a choice. For example, if the Fed raises its policy rate faster than is expected, the Loonie could continue to depreciate to the point when the BoC has no choice but to tighten its monetary policy in order to stop the bleeding.

Five-year Government of Canada (GoC) bond yields closed at 0.73% last Friday. Five-year fixed-rate mortgages are available in the 2.59% to 2.74% range, although the major banks are advertising much higher rates so it pays to shop around. Five-year fixed pre-approval rates are offered at rates as low as 2.79%.

Five-year variable-rate mortgages are available in the prime minus 0.50% to prime minus 0.35% range, which translates into rates of 2.20% to 2.35% using today’s prime rate of 2.70%.

The Bottom Line: The start of the new year is a good time to assess the key factors that will determine the direction of our mortgage rates over the next twelve months. While factors like $40/barrel oil, continued global instability risks and benign inflation rates in both Canada and the U.S. hint that both our fixed and variable mortgage rates should remain near today’s levels for the foreseeable future, wildcards like the plummeting Loonie and the Fed’s tightening timetable should keep us from becoming too complacent when putting our money where our mind is.