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As soon as the Bank of Canada believes it’s losing the battle on inflation, it’s going to take interest rates higher, regardless of whether the U.S. Federal Reserve is ready to do the same.

That’s when we’ll start the march toward judgment day, when we’ll know whether variable- or fixed-rate mortgagors made the right call.

In the past quarter century, Canada’s central bank has boosted its key rate independent of the Fed during three periods: 1997-98, 2002-03 and 2010. Implied future rates in the bond market suggests it’s going to happen again.

Some argue that low rates aren’t fuelling inflation, and therefore raising rates isn’t the key to bringing inflation back to its target of 2 per cent. But make no mistake, rate tightening is the Bank of Canada’s No. 1 tool. It works. As the bank has before, it’ll use that tool without hesitation to save its reputation as an inflation fighter, even if the Fed takes its sweet time.

So yes, expect some divergence between Canadian and U.S. rates, albeit not a vast divergence; that would drive up the loonie and hurt exports too much.

And if the Fed wakes up to the fact that it, too, is behind the curve on inflation, which just surged to a three-decade high of 6.2 per cent in the United States, the Fed will catch up to the Bank of Canada, posthaste.

What goes up must come down

We’re nearing a point at which five-year fixed mortgage rates are becoming mathematically risky, relative to variable rates. That is, if you believe the market’s ability to forecast interest rates.

The higher and faster interest rates and commodity prices (energy costs, for example) rise, the more rate hikes it’ll take to limit inflation. And hence, the closer we are to the next economic downturn.

This matters for mortgage shoppers because economic slowdowns, let alone recessions, generally result in rates reversing lower.

The market is already foreseeing it. Investors believe the Bank of Canada will need to boost rates at least 175 basis points (bps) to control inflation in the next two years. But that hiking will slow the economy so much that it’ll lead to rate cuts in 2024, according to overnight index swap pricing, as tracked by Bloomberg. (There are 100 basis points in a percentage point.)

What’s the risk of you choosing the wrong mortgage rate?

We are heading into the most challenging period to own a home since the interest rate surge of the early 1980s

That’s why the yield curve is flattening, meaning the gap between long-term rates and short-term rates is shrinking.

If this “spread,” as they call it, compresses too much, we get an inverted yield curve. That would signal a high likelihood of recession – and lower mortgage rates.

If you look at today’s spread between Canada’s 10-year bond and its two-year bond, it’s down to 0.68 per cent, 65 bps lower than in the spring. Indeed, rate expert Ian Pollick at CIBC Capital Markets noted in a report earlier this month that Canada’s yield curve is “entering the coming hiking cycle flatter than it ever has been this far ahead of actual rate hikes.” Highly unusual.

RBC Capital Markets summed up why in a recent report: “Canada has less space to tighten aggressively given more elevated levels of household debt.”

One plausible rate path

As this is being written, implied pricing in the bond market shows Canadian rates peaking after just two years, and then falling slightly in 2024 for the reasons above. Mortgage shoppers can’t rely on that, unfortunately. It’s just a projection that will undoubtedly change. But it does reinforce how bond traders believe that rate hikes won’t last.

If rates do jump as much as the market currently projects through 2023, it would take just two rate cuts in 2024 or 2025 for today’s lowest widely available uninsured variable rate (1.34 per cent) to beat a 2.59-per-cent fixed rate with similar features, based on interest cost alone. A note for default insured borrowers: Some regional online brokers, such as Butler Mortgage in Ontario, British Columbia and Alberta, now advertise effective variable rates at a record low 0.87 per cent.

Of course, market projections are fluid and often wrong. People also said that high rates would be short-lived in 1978, right before they exploded another 10 percentage points higher.

As much as inflation may surprise us, a 10-point runup in borrowing costs is not in the cards this time. Not even close. But if rising prices have staying power, meaning they’re not as “transitory” as central bankers say, the magnitude and persistence of higher rates could stun everyone, even the Bank of Canada.

If you can’t handle that risk but don’t want to pay the premium for a five-year fixed, consider a four-year fixed instead. You’ll find them up to 25 bps below the best five-fixed rates, depending on province. That 25 bps adds up to $3,000 of interest savings in the first four years, on a typical $300,000 mortgage.

Lowest nationally advertised mortgage rates

TERMUNINSUREDPROVIDERINSUREDPROVIDER
1-year fixed2.44%RBC1.99%True North
2-year fixed2.08%Scotia eHOME1.99%Multiple
3-year fixed2.18%Scotia eHOME2.13%Scotia eHOME
4-year fixed2.33%Scotia eHOME2.19%Nesto
5-year fixed2.54%Tangerine2.24%Marathon
10-year fixed3.30%First National3.04%HSBC
5-year variable1.34%Simplii0.99%HSBC
HELOC2.35%TangerineN/AN/A

Source: Robert McLister; data as of Nov. 10

Rates shown in the accompanying table are 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. Rates are based on a 25-year amortization.

Robert McLister is an interest rate analyst, mortgage planner and contributing writer for The Globe and Mail. You can follow him on Twitter at @RobMcLister.

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