Why the Gap Between Fixed and Variable Mortgage Rates May Widen
December 8, 2014Five Factors That Will Drive Canadian Mortgage Rates in 2015
January 5, 2015
Last week was an eventful one for mortgage rates and for residential real estate in general.
For starters, we saw five-year Government of Canada (GoC) bond yields plunge to 1.31%, which marks their lowest level in eighteen months. This was a stark reminder that the outside world still views Canadian economic momentum through an oil-tinged lens.
Some argue that this reaction is overblown. Canadian energy production accounts for approximately 6% of our total GDP and 21% of total exports, making energy a significant, but not dominant, contributor to our overall economic output. But markets respond to changes at the margin, and in that vein, the recent drop in both the Loonie and our bond yields makes more sense – especially when you consider our oil patch has created the largest share of new, higher-paying jobs since the start of the Great Recession, and that this sector has been leading the nascent rebound in business investment, which Bank of Canada (BoC) Governor Poloz has long maintained is a vital element in every one of his healthy-recovery scenarios.
In that context, the market response seems justified, even if it exacerbates an ongoing concern for our policy makers: namely, that falling bond yields might reinforce a ‘low-rates forever’ borrower mentality at the same time as our slowing economic momentum gives the BoC less flexibility on the timing of its next policy-rate increase.
So with his hands tightly tied, what is our BoC Governor to do? For starters, cue the latest Financial System Review (FSR), and more specifically, the section devoted to the potential over-valuation of our housing market on pages 15 and 16.
The section itself seems rather benign, at least to this reader. The Bank starts by explaining the difficulty in developing a benchmark for house-price values because they are determined by the interplay of many different variables, some of which are specific to individual countries and/or specific localities (such as land restrictions in Hong Kong and Vancouver). It then cites reports from well-known sources (although how the IMF has any credibility left as a forecasting authority remains a mystery to me) and offers its own findings that average Canadian house prices may be over-valued by anywhere from ten to thirty percent.
The Bank observes that its model shows some consistency between current house prices and those that were in place in 1981 and 1990. Both of those periods coincided with significant house price corrections. But crucially, the Bank acknowledges that those corrections were preceded by a much sharper rise in house prices and interest rates, and were accompanied by tighter monetary policy, which was necessary to lean against rising inflationary pressures. Those were key elements, and they are largely absent from current forecasts for the Canadian economy. So while over-valuation of Canadian real estate is certainly a concern worth highlighting in a report covering the risks to our financial stability, the BoC isn’t forecasting the kind of imminent doom that we are used to reading about in Maclean’s.
Much of the mainstream media seized on the worst-case scenario in the Bank’s analysis and treated it like a base-case forecast. While it makes for a less splashy headline, the BoC’s prevailing view is that “a soft landing is the most likely way forward” and that overall financial-system risks are now perceived to be lower than they were when the most recent FSR report was published in June. Furthermore, the following day, when speaking to reporters about the housing market in New York, Governor Poloz said, “we don’t think of this as a bubble in any way”, probably in an attempt to offset the media’s outsized reaction to its over-valuation analysis.
Before that last paragraph paints me as just another self-interested real-estate industry professional, who can’t see past his nose when it comes to responsibly managing the stability of our economy, let me add the following:
- Governor Poloz also said in New York that a sustainable Canadian recovery will need to be accompanied by a reduction in credit availability. In others words, he thinks that Federal Finance Minister Joe Oliver is going to have to tighten lending regulations again.
- I have supported all four rounds of changes made to our mortgage lending policies thus far and am broadly in favour of more changes if our policy makers deem them suitable, and if they are applied with the same precision and care as those made previously.
- When I say that the media over-reacted to the Bank’s worst-case scenario in its over-valuation analysis of house prices, I am not saying that we should not be worried about the sustainability of today’s house prices levels. The fact is, our house prices have risen in response to falling interest rates for some time, and since interest rates aren’t likely to fall much further, the main catalyst for house price appreciation over the last many years has largely been exhausted. This certainly increases the possibility that a drop in house prices could occur, and going forward, even a best-case scenario implies a much more subdued rate of appreciation, since house prices should much more closely correspond with changes in average income levels.
When trying to analyze the health of our real estate market, try as we might, it is impossible not to let our personal experiences influence our view. To that end, when my wife and I bought our house in mid-town Toronto in 2003 we were concerned that the market was due for a correction, and we almost didn’t buy for that reason. So, like many, I have lived with over-valuation fears for some time. Granted, the continued presence of this threat may have dulled my sensitivity to it, but so too does it seem to have made others overly hasty in concluding that any rational discussion by our policy makers about house-price risks is a sure-fire signal that the end is nigh.
Five-year GoC bond yields dropped eighteen basis points last week, closing at 1.31% on Friday. Lenders are much slower to lower their rates than they are to raise them and as such, five-year fixed-rate mortgages remain in the 2.79% to 2.89% range, while five-year fixed-rate pre-approvals are offered at 2.99%.
Five-year variable-rate mortgages are available in the prime minus 0.65% to prime minus 0.80% range, depending on the terms and conditions that are important to you.
The Bottom Line: BoC Governor Poloz is right to highlight the risk that our house prices may be over-valued, but like every other responsible observer who tries to measure this risk, he recognizes the limitations inherent in the data. Those in the mainstream media would do well to remember the same.