Why the Gap Between Fixed and Variable Mortgage Rates May Widen

Last week the Bank of Canada (BoC) left its overnight rate unchanged as expected.

It has now been more than four years since the BoC last moved this rate, and given that this is the rate that our variable-rate mortgages are priced on, that means that anyone who took out a variable rate on or after September 2010 is still waiting for their first rate change.

(This makes me wonder if it is time to revisit Kevin O’Leary’s dire warning two years ago that variable-rate borrowers would “get slaughtered” if they didn’t lock in a fixed rate immediately. Rereading that article reminds me of Andy Capp’s famous quote about how “those who know the least always seem to know it the loudest”.)

Here are the highlights from the accompanying BoC commentary, which reads to me like a textbook example of a neutral interest-rate policy statement:

• Inflation “has risen more than expected”, but this “is largely due to the temporary effects of a lower Canadian dollar and some sector-specific factors”.
• “The U.S. economy has clearly strengthened … which has benefited Canadian exports … but growth in the rest of the world, in contrast, continues to disappoint …”
• “Canada’s economy is showing signs of a broadening recovery … [which] suggests that the hoped-for sequence of rebuilding that will lead to balanced and self-sustaining growth may finally have begun. However, the lower profile for oil and certain other commodity prices will weigh on the Canadian economy.”
• “The net effect of these recent developments, together with upward revisions to historical data, is that the output gap appears to be smaller than the Bank had projected in the October Monetary Policy Report (MPR). However, the labour market continues to indicate significant slack in the economy.”

The most noteworthy change in the BoC’s carefully worded statement was its reference to our household debt levels. In its previous statement the Bank viewed the risks associated with what it calls “household imbalances” as “edging higher”, but last week the BoC was much more pointed when it said that these household imbalances “present a significant risk to financial stability”.

This reads to me like the latest salvo in a long running tug-of-war between the BoC Governor on the one hand, who laments that household debt levels are dangerously high but that raising rates is too blunt a policy tool for addressing this problem, and our Federal Finance Minister on the other hand, who is reluctant to tighten regulations for a fifth time in order to reign in market forces – especially with a federal election on the horizon.

The BoC’s warning follows a familiar pattern of late, where stronger than expected low-season (winter) demand in our major real-estate markets alarms our regulators, who then respond by announcing policy changes, which have now become a rite of spring. The Bank’s choice of language about household imbalances is essentially right on cue – the first steps of a familiar dance.

The BoC commentary wasn’t the only economic news making headlines last week. We also received the latest U.S. and Canadian employment reports, and here are the highlights from each:

The U.S Non-Farm Payroll Report for November

• The U.S. economy added 321,000 new jobs in November. This was more than 100,000 jobs above what the consensus was expecting and it marked the best one-month tally for new jobs  in more than two years.
• Average hours worked expanded from 34.5 hours to 34.6 hours, and while this may not seem like a big increase, David Rosenberg estimates that this uptick is equivalent to adding 400,000 extra jobs to the U.S. economy.
• Average hourly earnings also rose by 0.40%. When combined with the expansion in average hours worked, Rosenberg estimates that actual earnings surged by 0.7% last month, which equates to 8% wage growth on an annualized basis. This is significant because until recently, improvements in U.S. job creation have not corresponded with meaningful wage increases. This meant that the purchasing power of the average U.S. consumer was barely keeping pace with inflation, which left doubt about how sustainable any uptick in U.S. economic momentum could be. If earnings continue to grow at this pace however, the U.S. recovery will look much more healthy and sustainable.

The Canadian Labour Force Survey for November

• The Canadian economy lost 10,700 jobs in November. That said, there has been a lot of volatility in our headline employment numbers from month to month and our economy added 117,000 new jobs in the two months prior.
• The manufacturing sector shrank by an estimated 400 jobs last month. Again though, this sector added 40,300 new jobs in the two prior months so most of the recent momentum in manufacturing is still positive on balance. These jobs matter more than most because research shows that, on average, each manufacturing job creates a powerful multiplier effect that leads to the creation of other jobs throughout our broader economy.
• The private sector shed 45,600 jobs last month after adding 194,000 new jobs in the two months prior.
• Average hours worked fell 0.5% and average earnings fell 0.1%, when compared to the September data. These trends continue to concern policy makers because average earnings have only increased by 1.6% over the last twelve months. This means that the purchasing power of the average Canadian is shrinking because general price levels, as measured by the consumer price index (CPI), rose by 2.4% over the same period.

Interestingly, when the U.S. and Canadian employment data were released on Friday, five-year Government of Canada (GoC) bond yields surged six basis points higher, which was a counterintuitive market response to the weak Canadian report. This happened because the strong U.S. employment report, and the uptick in U.S. bond yields that it caused, had more importance to Canadian bond-market investors than our own weaker-than-expected domestic data.

If you’re surprised by that, you shouldn’t be. There has always been a relatively high correlation between U.S. and Canadian bond yields but since the start of the Great Recession, GoC bond yields have basically followed changes in their equivalent U.S. treasury yields in lockstep.

Thus, if you are in the market for a mortgage, remember that today’s fixed rates are primarily determined by changes in U.S. economic momentum, whereas variable rates are primarily a bi-product of our domestic economic performance (because they are based on the overnight rate, which is directly controlled by the BoC). If the momentum gap between our two economies widens over time, expect the gap between our fixed and variable mortgage rates to widen with it.

Five-year GoC bond yields rose eleven basis points last week, closing at 1.49% on Friday. Five-year fixed-rate mortgages remain in the 2.79% to 2.89% range, and 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: The BoC maintained its neutral policy stance last week, and in doing so, gave numerous examples of where sources of positive economic momentum were being roughly offset by negative equivalents. On Friday, the latest U.S. and Canadian employment reports provided another illustration of these countervailing forces at work, with U.S. job strength being matched by Canadian job weakness. If that divergence continues, expect fixed mortgage rates to rise while variable rates lag behind.