Mortgage Rundown: Market versus Bank of Canada – who will prove right on rates?

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Welcome to the latest edition of Mortgage Rundown, a quick take on Canada’s home financing landscape from mortgage strategist Robert McLister.

Canada no longer needs near-zero interest rates, so says a growing chorus of economists. The Bank of Canada thinks otherwise.

After leaving its key lending rate at its rock-bottom low, the bank effectively told variable-rate mortgagors on Wednesday that they can keep enjoying historically cheap borrowing costs. That is, until “the middle quarters of 2022.”

That means the prime rate could potentially remain at 2.45 per cent as late as September, 2022. The market doesn’t buy it.

Despite the bank’s guidance, investors believe it will have to hike by March to avoid losing public confidence amid escalating inflation. Surging prices are now water-cooler conversation. That’s a problem for a central bank that’s spent the past three decades building its credibility as an inflation fighter.

The longer Canadians see it doing nothing to thwart multidecade highs in the consumer price index, the more they’ll rush to beat price increases, ask for higher wages and pour into inflation hedges such as real estate. That could trigger a self-fulfilling inflation scare that forces the bank to act more aggressively than is currently necessary.

The data are arguably not on the bank’s side. December inflation is expected to blow past 5 per cent as Canada nears full employment, wages are starting to surge and the last time unemployment was this low, the prime rate was 150 basis points higher. (There are 100 basis points in a percentage point.)

Despite the Bank of Canada being at odds with the market, and leaving aside unknowable risks such as the number (and economic impact) of continued virus waves, rate hikes are coming. As a mortgagor, Job No. 1 is positioning yourself in the right term given your risk appetite and affordability constraints.

Investors are betting that rates rise two percentage points in the next two to three years, according to Bloomberg data. But, interestingly, consumer sensitivity to rate hikes has those same investors betting that rates will start drifting lower again before the end of 2025.

Given this outlook and current pricing, and assuming you need a new mortgage for at least five years, there are currently four sensible options:

· Five-year fixed – The best insurance against high inflation;

· Five-year variable – Only for the financially secure and risk tolerant, especially those with a modest mortgage relative to income, a short amortization, or a potential need to break their mortgage early;

· Three-year fixed, renewing into a variable – Affords some rate protection, is a quarter-point cheaper than a five-year fixed and gives you options in 2024;

· Five-year hybrid – Half fixed and half variable to diversify rate risk.

Rate simulations based on implied rates in the bond market still give the five-year fixed a narrow projected edge, despite the variable’s roughly 130 bps starting rate advantage.

That said, unless the Bank of Canada is wrong and excessive inflation lasts well past 2022, rates shouldn’t significantly exceed the bank’s 2.25-per-cent long-term neutral rate estimate. That means you probably won’t see a huge borrowing cost disadvantage in any of these terms.

Don’t root for lower insurance premiums

Overstretched first-time buyers want to save every buck they can, but the Liberal government’s proposed 25-per-cent reduction in default insurance premiums isn’t the way to do it. Not only would it promote incremental housing demand and reduce the capital buffers that protect taxpayers from the unlikely event of insurer insolvency, but it could also reduce insurance availability.

If default insurers lost 25 per cent of their revenue, they’d be forced to raise their minimum credit scores for a default insured mortgage – I’m hearing to as high as 740 – in order to manage risk and ensure a sufficient return on equity. Based on insurer data, that could potentially shut out as many as one in six potential insured borrowers. If that happens, someone buying a home with less than 20 per cent down and slightly below-average credit could be left with fewer, more expensive borrowing options.

Variable rates tick higher

The big move in variable rates won’t come until the Bank of Canada hikes start pushing up the prime rate. But floating rates also climb when lenders reduce their discounts to the prime rate. And that’s what we saw this week.

Fixed rates were mostly unchanged, but the lowest nationally advertised uninsured variable rate edged one basis point higher.

The leading insured variable rose nine bps, but you can still find brokers in some provinces advertising as low as 0.85 per cent.

Rates in the table are as of Dec. 8, from providers that lend in at least nine provinces and advertise rates on their websites. Insured rates apply to those buying with a down payment of less than 20 per cent, or those switching a pre-existing insured mortgage to a new lender. Uninsured rates apply to refinances and purchases of more than $1-million and may include applicable lender rate premiums.

This & that

• Extend it out: I just heard a commentator suggest people get the shortest amortization they can. Horrible advice in a high-inflation environment. What you want to do is extend your amortization as much as possible so you can pay your fixed mortgage payment with future dollars. Then invest the spare cash flow this creates in more inflation-resistant investments.
• MQR watch: The Office of the Superintendent of Financial Institutions, Canada’s banking regulator, could hike the minimum qualifying rate (MQR) this month, making it harder to qualify for a mortgage. If it does, I’d bet on the increase being anywhere from 15 to 45 bps. This would have a greater impact on home buyer demand than any single Bank of Canada rate hike.
• Muted rate impact: New COVID variants will keep cropping up but odds are, future variants won’t depress interest rates as much as in the past. The market appears to be progressively caring less – thanks to vaccine and treatment improvements. Hence, COVID risk alone is probably not a great reason to choose a variable rate.
• Mortgage inflation: The average new mortgage is now $360,098, according to the latest Equifax data, 18.3 per cent higher than last year. That’s on top of a hike of 80 bps-plus in average five-year fixed mortgage rates over that same time frame.

Robert McLister is an interest rate analyst, mortgage strategist and columnist. You can follow him on Twitter at @RobMcLister.