Fixed Versus Variable Rate Simulation: The Winner Is …December 2, 2013
Shovelling and ShoppingDecember 16, 2013
Last week the Bank of Canada (BoC) announced that it would once again hold its overnight rate at 1%, as was universally expected. But in a somewhat surprising move, the Bank significantly altered the language in its accompanying commentary.
Here are the key phrases from the BoC’s latest statement with my comments in italics:
- “The global economy is expanding at a modest rate”, “growth in emerging markets continues to ease”, and U.S. growth was “stronger than forecast” with “gathering momentum in the U.S. economy”. The BoC has been overly optimistic about the strength of the U.S. recovery since the start of the great recession so I would take its U.S. recovery projections with a grain of salt.
- Recent Canadian growth was “stronger than the Bank was projecting” but our economy has not yet rebalanced towards “exports and investment”. In other words, our economic momentum is still overly dependent on consumer spending (and rising household debt levels) but we’re still holding out hope that business investment and higher export demand will grasp the baton.
- “The Bank continues to expect a soft landing in the housing market”. Anyone who has been following the BoC’s forecasts for some time knows that it, like every other central bank, has a surprisingly bad forecasting record. Frankly, it’s hard for me to imagine the BoC forecasting a hard landing for the housing market, so I don’t draw any particular comfort from this observation and I think the media overplayed its significance.
- Despite the fact that the BoC sees business spending recovering “more slowly than anticipated”, the Bank still believes that our economy will gradually “return to full production capacity around the end of 2015.” If the factors that the BoC has been counting on to fuel positive economic momentum are taking longer to develop than anticipated, where is the corresponding positive offset to justify no change in the Bank’s overall view?
- “Inflation is being held down by significant excess supply and by the effects of heightened competition in the retail sector” which has been “more persistent than anticipated”. But not to worry because, without providing any underlying justification, we are still predicting that the economy will return to full capacity by the end of 2015 … which is easier than redoing the forecast and giving everyone a lump of coal in their stocking.
- “Downside risks to inflation appear to be greater”, but overall “the balance of risks remains within the zone articulated in October”. Unspecified “zones” are a forecaster’s best friend.
The BoC’s latest forecast represents a subtle but important shift in its view of what our economic future may hold. The Bank acknowledged that downside-inflation risks are a growing concern without altering its cautiously optimistic overall long-term view.
Its careful choice of words nudges the Bank from a neutral interest-rate stance to a slightly more dovish bias. Like the fine-tune dial on an old radio transmitter, emphasizing the risks of downside inflation is actually a subtle way for the BoC to stimulate our economy.
The Bank knows that global investors will reduce their Canadian dollar holdings if they see increased odds that our short-term rates will fall, in the same way that the BoC’s previous tightening bias helped push the Loonie higher.
True to form, the Loonie fell sharply after the BoC’s latest statement was released.
The BoC has to walk a fine line. On the one hand it wants to offer a more cautious view, which softens the Loonie, but on the other hand, it doesn’t want to scare off business investment, which it believes is the key to assuring sustainable economic momentum.
Forecasting is hard enough without having to overlay a whole series of competing objectives. That helps explain why the Bank gives itself ten chances a year to tweak its views and why it relies heavily on “zones” and “ranges” when weaving its carefully crafted web of words.
Government of Canada (GoC) five-year bond yields were 9 basis points higher last week, closing at 1.83% on Friday. Lender fixed rates were largely unchanged last week and market five-year fixed rates are available in the 3.35% range from lenders that offer reasonable terms and conditions.
Variable-mortgage rates are offered in the prime minus 0.55% range, which works out to 2.45% using today’s prime rate of 3.00%. To see how fixed- and variable-rate interest costs might compare over the next five years, check out my latest variable-rate simulation.
The Bottom Line: The potential savings inherent in today’s variable-rate mortgages continue to grow as the BoC tries to replace expectations of its next move being an overnight-rate increase with speculation that it may actually drop its rate instead. While I think the possibility of a rate drop is still remote under our current circumstances, variable-rate borrowers should take the Bank’s latest shift in emphasis as a reassuring signal that any potential rate increases should remain a long way off.