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Household Finances Mortgage shoppers looking to roll the dice on short-term rates should look at 1 or 2-year terms

Canada’s central bank has said no to rate cuts all year and, so far, that appears to have been a wise decision.

The Bank of Canada has rejected a knee-jerk monetary policy easing, despite its U.S. counterpart trimming interest rates by 25 basis points, an ominous recession-auguring yield curve and more than $15-trillion of negative yields across the globe.

Had it given in to market pressure and made a so-called “insurance rate cut” to protect against an economic slowdown, it might have needlessly boosted inflation, which, according to the bank, is currently “on target."

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Market action last week may have validated the bank’s decision. Just a day after the Bank of Canada announced it would hold its trend-setting overnight interest rate steady, longer-term bond yields in Canada and the United States blasted off. Canada’s five-year bond, which dictates fixed mortgage rates, surged 13 basis points on Thursday. If you’re a stat geek, that’s more than a three-standard-deviation move (a big deal). It hasn’t climbed like that in eight years.

The bond market is signalling that downside inflation risk isn’t as real as some believe. And the bond market, while far from fallible, is about as reliable a forecaster as you'll find.

Canada’s five-year yield was up again on Friday, trading at 1.323 per cent late in the day, reinforcing the shift toward market optimism. When rates move like this after a long downtrend, it’s rare to make new lows near-term.

That plays right into the BoC’s waiting-game strategy, an approach supported by recent trends such as:

  • Inflation that’s above the BoC’s target (albeit slightly);
  • Blockbuster job gains (Canada blew away forecasts Friday, adding an estimated 81,100 jobs last month);
  • An economy near capacity (the latest GDP print was well above expectations);
  • Resilient consumer debt growth;
  • An export-friendly 75-cent loonie;
  • A glimmer of trade hope (China and the U.S. agreed to talk next month).

On that last point, a U.S.-China trade pact would be like meth for rates. Other things equal, Canada’s five-year yield could recoup up to half of its losses since last fall – potentially spiking 50-plus basis points say some. Don’t forget, U.S. President Donald Trump’s disruptive trade conflict is what fuelled the big dump in yields in the first place.

Most of the above trends are lagging indicators, of course, but the message remains; inflation, which largely determines what you pay for a mortgage, shouldn’t be pronounced dead … not yet.

Two plays

At the risk of overgeneralizing, there are two broad flavours of borrower: those who are financially stable and risk tolerant (the lions) and those who are not (the lambs).

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If you’re among the former species, your sturdy finances let you risk potential rate pain in order to play the odds. Those odds suggest today’s best short-term deals on one- or two-year terms of 1.99 per cent to 2.25 per cent (default insured rates) and 2.19 per cent to 2.49 per cent (uninsured rates) will win given their historical outperformance and current disinflationary trends. Even if rates rebound after a historic trade deal, there is no imminent end to the cheap money era.

If you feel more like a lamb, rolling the dice on short-term rates won’t appeal to you, not when we have five-year fixed pricing near 2.25 per cent to 2.39 per cent (default insured rates) and 2.49 per cent to 2.69 per cent (uninsured rates). The payment risk is too great and their relative pricing (compared with short-term mortgages) is cheap. That’s true even though five-year fixed rates may be cheap for a reason and even though they lose more than they win long term.

One side note in case you’re wondering why there’s no mention of variable rates. The thing with variables is, you can’t trust the banks to lower prime rate in step with the Bank of Canada. That reduces the edge that variable rates once had. If the past few rate cuts are any guide, the BoC could cut prime rate by 75 basis points and banks might lower prime rate by only 45 basis points. If that happened, someone in today’s best conventional variable rate of 2.90 per cent could see their rate fall to just 2.45 per cent, still above today’s lowest short-term fixed rates. Meanwhile, you take all the risk of rates climbing. That’s why, despite their penalty advantage of just three months interest, variables generally aren’t worth it.

2020 is still a blur

Who can say if this week’s forceful rate reversal will fizzle once again? I can’t. Some pretty smart people, former Fed chairman Alan Greenspan being one, say negative rates in North America are ultimately unavoidable.

But if he’s right, it won’t be a one-way street to zero. While most investors expect average rates over the next five years to be lower, the odd inflationary scare could spike rates for months on end, limiting your potential gain with short-term rates (not a prediction, just a potential reality).

On the other hand, one must give street cred to historically reliable indicators (the inverted yield curve, bottoming unemployment, toppy consumer confidence, etc.), which hint that we’re not out of the woods for a recession. That’s why a one- or two-year fixed is a great option. They let you reset to a lower rate much quicker if the economic picture deteriorates. They also let you lock into a longer term sooner if rates escalate and imperil your budget.

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Either way, given how low rates are today, your risk of being wrong with a 2.49-per-cent five-year fixed is considerably less than it was in, say, 1980 … and 1990 … and 2000. And that five-year rate is just a smidge above its record low. So, if you’re not sure you want to be a lion, don’t be afraid to be a lamb.

Robert McLister is a mortgage planner at intelliMortgage and founder of RateSpy.com. You can follow him on Twitter at @RateSpy.

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