Inflation is making central bankers nervous, whether they admit it or not. That includes the most important central bank on Earth: The U.S. Federal Reserve.
This was obvious last Wednesday when Fed committee members, seeing core inflation approach multidecade highs, moved up their forecast for the next U.S. rate increases.
Fed members now expect two hikes in 2023, versus 2024 previously. Seven committee members expect a hike as soon as next year.
When the Fed gets more nervous, Canadian borrowers should get more nervous, for one simple reason: Fed policy usually determines, albeit indirectly, how much mortgage interest Canadians pay each month. That’s true whether the borrower has a variable rate or a fixed rate that’s coming up for renewal.
Fed equals dog, BoC equals tail
As goes the Fed, so goes the Bank of Canada, most of the time.
That’s why our five-year government bond yield, which leads fixed mortgage rates, surged the most in three months after the Fed’s recent announcement.
Investors know that there has never been a time in the modern era of monetary policy when the Fed raised rates and the BoC didn’t follow.
Of course, technically speaking, Canada’s rate direction hinges mainly on its own inflation expectations. And we should expect more inflation pressure this summer, Bank of Canada Governor Tiff Macklem told a Senate committee last Wednesday.
Thereafter, as “base-year effects fade, Governing Council expects the ongoing excess supply in the economy to pull inflation back down,” he predicted. (“Base-year effects” means inflation is overstated because it was temporarily low a year ago.)
That’ll be true to some extent, but with average core inflation surging to a 12-year high, economists aren’t buying all the central bank is selling.
The bank “keeps saying inflation is just a base effect phenomenon that will magically and permanently go away,” writes Bank of Nova Scotia economist Derek Holt. But that “remains a tough narrative to believe.” There’s ample evidence that some inflation is persistent, he says.
Either way, as the bank’s own forecasts have taught us, central bank rate projections are about as predictive as long-range weather forecasts. Anything could come out of left field and delay or accelerate rate increases.
Mr. Macklem doesn’t disagree, having suggested that the “timing” for rate hikes is “unusually uncertain given the difficulties in assessing” the economy. Yet, ironically, he’s confident enough to play down the decade-plus highs in consumer price index inflation.
No doubt there are many mortgagors out there saying, “I’m probably better off watching what the BoC does – not what it says.”
What to do about it
Barring more calamity, this economic recovery we’re in – one of the fastest recoveries in history – is virtually certain to bring higher rates. The Bank of Canada essentially admits as much with its 2022 rate-hike projection.
That brings us to the perennial question for most mortgage shoppers: fixed or variable?
Deep-discount variable rates are now about 0.93 percentage points below comparable five-year fixed rates. That’s nearing the widest fixed-variable spread in a decade.
Once that gap exceeds one to 1.25 percentage points, you’ll see a surge in borrowers taking their chances with variable rates. The bet is that the upfront interest savings of not locking in will outweigh the extra interest they’ll pay when prime rate marches higher.
That strategy is arguably riskier than usual. Record stimulus, supply constraints and record savings waiting to be spent, mean that inflation might not be as “transitory” as central banks suggest. If so, they risk being too late with rate hikes. That, in turn, risks inflation spiralling higher than necessary, taking mortgage rates higher than necessary.
The majority of borrowers are risk averse, especially when they hear Mr. Macklem say things like: “Interest rates are unusually low, which means eventually there’s more scope for them to go up.”
Most will just lock in for five full years and go on their merry way. Their worry is that six or more rate hikes, which the bond market expects, by the way, could leave them paying more than a floating-rate borrower.
More financially secure, risk-tolerant borrowers are willing to roll the dice on a variable. They believe the narrative that inflation may be short-lived and/or rates will revert lower before their five-year term is up.
Near the end of last year, when I was enthusiastically advocating fixed rates, the decision to lock in was easier. Fixed and floating rates were within a quarter-point of each other, and it was highly likely we were near the very bottom of the economic cycle.
Today, the wider spread leaves more room for error. But here’s the good news. You don’t have to pick sides.
If you prefer to hedge your bets, consider the often-ignored hybrid mortgage. At around 1.75 per cent, it’s built for this type of uncertainty. It’s kind of like a bond ladder where an investor buys both short and long-term bonds to manage interest-rate risk. Being 50-per-cent fixed and 50-per-cent variable, you’ll never be 100 per cent right on your rate call, but you’ll never be more than half wrong either.
Hybrid mortgages don’t get much love, but maybe they should. If Mr. Macklem isn’t sure how high interest rates will go, no one else knows either.