The Bank of Canada’s Latest Crystal Ball ReadingApril 22, 2014
Fixed Versus Variable Mortgage Rates: Finding the Break-Even PointMay 5, 2014
Last week Bank of Canada (BoC) Governor Stephen Poloz made a speech to the Saskatchewan Trade and Partnership (STEP) group, which offered useful insights into our economy and included additional commentary on where the Bank sees our interest rates heading.
I have come to appreciate Governor Poloz for his plain-spoken views on complex topics. Also, whereas I tended to believe that former BoC Governor Mark Carney was ‘talking past’ specific questions and using his rhetoric as a policy tool to influence predetermined objectives, I find that Governor Poloz is much more willing to call a spade a spade. (You can watch the speech and the accompanying press conference to decide for yourself.)
Here is a summary of my key takeaways from Governor Poloz’s most recent comments:
On Exports …
Governor Poloz believes that the Canadian economy needs an export-led recovery in order to achieve sustainable and healthy long-term economic growth. Economic growth that is fuelled by rising house prices and/or increased consumption is “simply not sustainable”.
When the U.S. economy entered the Great Recession, the impact on our export-based manufacturers was severe. Instead of merely cutting back in response to lower demand, many of these companies went out of business altogether. While this is part of the normal creative destruction that small, open economies like ours must navigate when the business cycle shifts, our current recovery is taking longer than normal because it requires the creation of new businesses to meet changing export demand. This is different from what we experience after a garden-variety recession, where our existing export manufacturers simply ramp up production when demand recovers, and this is the biggest reason why the Bank believes it will still be some time before we see “a convergence between our export growth rates and the growth rate of foreign demand”.
The BoC is forecasting that our output gap (the difference between our actual output and our maximum potential output) will disappear in early 2016. But Governor Poloz candidly acknowledged that this forecast is based on anecdotal feedback from businesses and is “not actually in the numbers yet”.
We need to see rising export demand before a pickup in business investment can follow, but this popularly dubbed ‘virtuous cycle’ will take more time to evolve for the reasons outlined above.
“Growth since the crisis has been fuelled by policy, not by natural forces”. Did I mention that I love the governor’s candour? My continuing doubts about the strength of the U.S. recovery centre on my uncertainty around what will happen when the U.S. Federal Reserve completely withdraws its quantitative easing (QE) programs. The Fed is betting that natural U.S. economic forces have now achieved self-sustaining momentum, which will continue when QE is stopped. Given that the U.S. economic growth has been underpinned by an unprecedented level of both fiscal and monetary policy stimulus over the past five years and counting, I would argue that this assumption is not in the numbers either.
On Interest Rates …
There is too much uncertainty around Canada’s export future for the BoC “to have anything other than a neutral interest-rate view” for the time being.
While the BoC expects that it will take “about two years” before inflation returns to the Bank’s 2% target, there are other factors that will keep our interest rates lower than might be anticipated when relying on historical comparisons. For example, our aging population is triggering a demographic shift that will lower our economy’s rate of output. Also, Canadian consumers are now more indebted, and this makes them more sensitive to interest-rate movements, which means that the impact of interest-rate increases will be more immediately, and profoundly, felt. These factors, which now affect many developed countries, will foster a lower natural “equilibrium” interest rate for our economy and “there is a growing consensus that [future] interest rates will be lower than those in the past.”
So what does this lower for longer interest-rate view mean for mortgage borrowers? Does it mean that we should all run out and secure variable-rate mortgages without considering fixed-rate alternatives?
Not so fast.
While existing variable-rate holders have increased confidence that their borrowing costs are not likely to rise any time soon, assurances to that end only satisfy some of the criteria used to make the age old fixed-versus-variable rate call.
The size of the gap between fixed and variable rates is an equally important consideration, and the BoC’s increasingly benign inflation view has helped push our five-year fixed rates back below 3%. (When investors expect less future Canadian inflation they are willing to accept lower yields on longer-term Government of Canada (GoC) bonds and this, in turn, pushes our fixed mortgage rates down.)
Fixed-rate borrowers see the gap between fixed and variable rates as the ‘rate-insurance premium’ they must pay for the stability of knowing what their payments will be for the next five years. Whereas variable-rate borrowers see the discount they get when opting for a variable rate as their ‘margin of safety’, which describes the amount by which their variable rate would have to rise before it would be more expensive than today’s fixed-rate alternative. Today, the gap between five-year fixed and variable rates is now in the neighbourhood of 0.60%, making variable-rate mortgage options a tougher call than when that gap was as wide as 1.00% (as recently as last June) or even 0.80% (as recently as this past February).
On balance, I still like the saving that can be achieved with today’s five-year variable rate, especially when variable-rate borrowers set their payments based on the five-year fixed-rate equivalent (which I outline in this Rob Carrick interview, filmed this past February). But as the gap between variable and fixed rates narrows, the choice between them becomes more difficult. So while I still have a mild preference for variable rates, my enthusiasm for this option is now somewhat tempered by the reduced relative saving it offers.
Side note: On Friday of last week CMHC announced three new changes to its policies for high-ratio mortgage insurance: 1) Borrowers (and co-borrowers who sign for children, siblings, etc.) are now limited to one CMHC high-ratio insurance policy at a time, 2) CMHC will no longer offer high-ratio insurance on second homes, and 3) Self-employed borrowers must now be able to prove their income through traditional means.
CMHC estimates that these changes will affect less than 3% of their overall high-ratio business volume. Interestingly, Canada’s private mortgage insurers, Genworth and Canada Guaranty, have not confirmed whether they will also adopt these changes, something they have been quick to do in the past.
I think CMHC should continue to pull back on its market coverage. In this post, which I wrote in June 2010, I argued “in a perfect world CMHC would act as a ‘market maker’ to ensure a minimum standard for high-ratio borrowers, which private market competitors would then augment with more flexible solutions, based on risk-based pricing and investor demand that would ebb and flow in response to market conditions.” These changes are a continuation of that evolution and as such, I think they will ultimately prove to be a healthy form of short-term pain for long-term gain.
Five-year GoC bond yields fell by five basis points last week, closing at 1.67% on Friday. Five-year fixed mortgage rates are offered in the 2.84% to 2.99% range, and five-year fixed-rate pre-approvals can still be had at rates as low as 3.09%.
Five-year variable-rate mortgages are offered at rates in the prime minus 0.65% range, which works out to 2.35% using today’s prime rate of 3.00%.
The Bottom Line: Last week BoC Governor Stephen Poloz succinctly explained why our economic recovery has taken longer than many were expecting, why our interest rates will stay low for at least the next two years, and why they will then rise more slowly than would typically be expected because of our long-term demographic changes and our higher overall borrowing rates. His commentary suggests that both our fixed and variable rates should stay at or near today’s ultra-low levels for the foreseeable future, but for the reasons outlined above, that reassurance doesn’t make deciding between these two options any easier.