Does It Still Pay to Shop Around for the Best Mortgage Rate?August 28, 2017
How the Loonie’s Value Is Likely to Impact Canadian Mortgage Rates In the Near FutureSeptember 18, 2017
The Bank of Canada (BoC) surprised markets last Wednesday when it raised its policy rate by 0.25%. Another rate rise had been expected before the end of the year, but the consensus believed that the Bank would wait until its October meeting.
To briefly recap, the BoC cut its policy rate twice in 2015 (by 0.25% each time) in response to the oil-price shock, and in early 2017 it assessed that our economy’s adjustment to lower oil prices was now close to completion. This served as a warning that those two emergency rate cuts would soon be clawed back and the only question left was the timing of when this would happen.
The reversal of the first 0.25% happened in July when the BoC raised its overnight rate from 0.50% to 0.75%. Then last week, after seeing that our annualized GDP growth came in at a whopping 4.5% in the second quarter, the Bank felt emboldened to unwind its second oil-related emergency cut by raising its overnight rate from 0.75% to 1.00%.
Lender prime rates, which our variable-rate mortgages are priced on, move in lock step with BoC overnight-rate increases, so variable-rate borrowers have just experienced their second 0.25% rate bump since July, after more than seven years with no increases.
Market watchers also keyed in on the BoC’s observation that “today’s removal of some of the considerable monetary policy stimulus in place is warranted” in its accompanying statement. The carefully placed word “some” has been interpreted as a signal that the Bank may raise again before the year is out.
In today’s post we’ll briefly look at the impact that this latest rate increase is likely to have on borrowers and house prices and then I’ll offer my take on the likelihood that the BoC will raise again before the end of the year.
From a practical standpoint, the latest rate hike will have only a minor impact on variable-rate borrowing costs. For example, a 0.25% rate increase adds about $12/month in interest cost for every $100,000 borrowed. Even with the last two rate increases included, our current average mortgage rate still sits at 3.25%, which is a little below our average mortgage rate of 3.3% over the past five years (hat tip to economist David Rosenberg for that statistic), and our average debt-service ratio remains below its long-term historical average.
Concerns about the affordability of this increase have also been mitigated by the mortgage rule changes made in 2010 which require variable-rate borrowers to qualify using a stress test that proves that they can afford for their rate to more than double. That onerous qualifying standard ensures that today’s variable-rate borrowers are better positioned to withstand rate increases than ever before.
There is also concern that the latest rate increases may have a negative impact on our housing markets, but those shouldn’t materialize if the BoC is, in fact, reading our economy right.
The Bank is raising rates because it believes that our economy now has achieved sustainable momentum. If that assessment is correct, average income growth will accelerate and that will expand affordability for purchasers (to read a more detailed explanation of my view on that topic, see my post titled Do Higher Interest Rates Cause Lower House Prices?).
If our current run of “stronger than expected growth”, which the Bank calls “broadly-based and self-sustaining”, continues to be underpinned by “solid employment and income growth”, we could well see another rate increase before the end of year.
In addition, all else being equal, the Bank would probably prefer to continue raising rates because it will help reduce the systemic risks that have built up during our extended period of ultra-low interest rates, while also giving it more room to lower rates the next time our economy falls into recession. But if the Bank holds true to its claim that its policy-rate path is “not pre-determined and will be guided by incoming economic data”, there are at least three significant obstacles that stand in the way of additional policy-rate increases in the near future:
- The surging Loonie – In the first half of this year, the Loonie generally fell against the Greenback, dropping to a little below 73 U.S. cents in early May. Since then it has been on a tear, closing above 82 cents last Friday. That significant change in value has impacted U.S. demand for our exports (which were down 5% in July). It’s true that the Greenback has lost value against most major currencies of late, and that somewhat blunts the impact of the Loonie’s rise because the countries it competes with for U.S. export demand have also seen their currencies appreciate against the Greenback. But the Loonie’s most recent surge is specifically tied to Canadian strength, not U.S. weakness. That makes it less likely that other currencies will continue to mirror the Loonie’s path. Also, the falling Greenback makes U.S. domestic producers more competitive in their home markets and this too reduces demand for our exports. The BoC knows that additional rate increases will exacerbate the competitiveness challenges that our exporters face and strengthen a headwind that is already acting against our economic momentum. That will be especially true if the U.S. Federal Reserve holds its policy rate steady for the remainder of the year, as the consensus now expects.
- Low inflation – The BoC’s core mandate is to “preserve the value of money by keeping inflation low and stable”. That means that the Bank should care as much about below-target inflation as it does about above-target inflation, but its actions have at times belied that objective because our inflation measures have spent most of the past five years below the BoC’s 2% target level, which the Bank has tolerated without too much concern. More recently, the BoC has moved much more pre-emptively to curtail rising inflationary pressures, and if it is to hold remotely true to its mandate, it should now hold off on additional tightening until we start to see a material uptick in our inflation gauges. Put another way, while it’s true that the BoC has said that its policy needs to “anticipate the road ahead”, it now needs to give reality some time to catch up. When I look at that road, I see further disinflationary pressure from the surging Loonie, from labour costs that remain well contained, and from declining U.S. inflation rates (which matter because we tend to import U.S. inflation rates over time). In short, I can’t see the Bank raising its policy rate again before we see a meaningful uptick in our key inflation measures because it can only “anticipate” so much and for so long.
- Lacklustre wage growth – Our economy has seen healthy job creation over the past twelve months but confoundingly, that impressive run has coincided with average wage growth of only about 2.5% over the same period. While labour costs do tend to lag other economic indicators, they should be rising more rapidly in the current context. The BoC acknowledged this in its latest statement when it noted that “wage and price pressures are still more subdued than historical relationships would suggest, [and] as observed in some other advanced economies.” If the economic models the BoC relies on can’t explain why incomes (and prices) haven’t risen more quickly, that makes them less useful tools for trying to “anticipate the road ahead”. This disconnect should make the BoC cautious about continuing to tighten monetary policy before it sees a material and sustained improvement in the income data as well.
Thus far, the bond market hasn’t bought into the speculation that the BoC will continue to raise rates in in the near future. For example, while the BoC has now raised its policy rate by 0.50% since July 12, five-year Government of Canada (GoC) bond yields have increased by only 0.20% over the same period. If bond market investors shared the BoC’s view that higher inflation was around the corner, longer-term bond yields should have already risen by more than 0.50% because they are more sensitive to changes in the inflationary outlook (by virtue of their duration).
Perhaps, like me, bond-market investors are less likely to price in a materially different “road ahead” when the facts on the ground are still less than conclusive, and when even the BoC acknowledges that its future policy-rate path is susceptible to “significant geopolitical risks and uncertainties around international trade and fiscal policies”.
Five-year GoC bond yields rose twelve basis points last week, closing at 1.72% on Friday. Five-year fixed-rate mortgages are still available at rates as low as 2.74% for high-ratio buyers, and at rates as low as 2.79% for low-ratio buyers, depending on the size of their down payment and the purchase price of the property. Meanwhile, borrowers who are looking to refinance can find five-year fixed rates in the 3.09% to 3.24% range.
Five-year variable-rate mortgage discounts remain largely unchanged and are still available at rates as low as prime minus 0.90% (2.30% today) for high-ratio buyers, and at rates as low as prime minus 0.75% (2.45% today) for low-ratio buyers, again depending on the size of their down payment and the purchase price of the property. Borrowers who are looking to refinance should be able to find five-year variable rates around the prime minus 0.50% to 0.40% range, which works out to between 2.70% and 2.80% using today’s prime rate of 3.20%.
The Bottom Line: While the BoC’s last two rate rises were relatively easy to foresee, its next move will be harder to predict. We have seen some encouraging improvement in the economic data of late but with the Loonie continuing to surge, inflationary pressures still largely dormant and average incomes rising at a confoundingly slow rate, I think it is unlikely that the BoC will raise its policy rate again until we see material and sustained changes in more of our economic data. Given that, if you’ve got a variable-rate mortgage my advice is to stay the course because I continue to believe that over the long run, steadfastness will still lead saving.