Dave Larock in Monday Interest Rate Update, Mortgages and Finance, Home Buying, Toronto Real Estate News Editor's Note: Dave's Monday Morning Interest Rate Update appears on Move Smartly weekly. Check back weekly for analysis that is always ahead of the pack.
Last week we heard new economic commentary from both Bank of Canada (BoC) Governor Stephen Poloz and U.S. Federal Reserve Chair Janet Yellen. Today’s post will summarize what they said and draw out the implications for both fixed and variable mortgage rates.
On Tuesday, BoC Governor Poloz offered a candid assessment of Canada’s current economic prospects when he spoke to the Halifax Chamber of Commerce. Here are my key takeaways:
- Canada’s output gap is not likely to close for “a couple of years”. The output gap represents the difference between our economy’s maximum potential output and its actual output today. It serves as a key indicator for the timing of the BoC’s next overnight rate increase because the BoC will typically raise rates as the output gap comes close to closing. Conversely, if the Bank thinks that the output gap won’t close for a couple of years, this means that variable rates, which are priced on the BoC’s overnight rate, should remain low for a similar period.
Governor Poloz’s comments imply that the BoC is a long way from raising its overnight rate. In fact, he recently indicated that the BoC’s next rate move might be down instead of up (a development that I first speculated about over a year ago).
Before Canadian mortgage borrowers breathe a sigh of relief, let’s check in with U.S Federal Reserve Fed Chair Janet Yellen.
On Wednesday of last week, the U.S. Federal Reserve decided to taper its quantitative easing (QE) programs by another $10 billion in April, continuing along its intended path of completely unwinding QE by the end of this year. At the press conference that accompanied the release of its official statement, Fed Chair Yellen gave her insights into what might be in store for U.S. interest rates in the near and medium-term future.
Here are the highlights of what she and the Fed said:
- The Fed has, for some time, used unemployment rate targets to give the market a measure with which to gauge the timing of future Fed rate hikes. In its Wednesday press release, the Fed said that it had “updated” its forward guidance and would now “take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.” This was probably the right thing to do. Changes in the unemployment rate are caused by many factors, and when it falls, it doesn’t always do so for ‘healthy’ reasons. The Fed has already lowered its unemployment rate targets several times when they were reached, and it lost a little more credibility each time it did this. Right move or not, the markets didn’t like this change because using a multitude of data makes for more guesswork from those who are trying to discern the Fed's future plans.
- The Fed has repeatedly reassured markets that it will not begin to raise short-term rates for a “considerable period” after all of its QE programs have been completely unwound. When asked to define that lag at Wednesday’s press conference, Fed Chair Yellen said “something in the order of six months, or that type of thing”. Markets reacted instantly, pricing in a Fed rate hike by mid-2015. Ms. Yellen’s extemporaneous comment reminded me of the first time that Ben Bernanke talked about tapering, and true to form, the Fed seemed to backtrack on this statement almost as soon as it was uttered. For my part, I think Fed Chair Yellen was crazy like a fox, floating a trial balloon: a) to see how markets would react to the prospect of higher rates, b) to keep speculators honest and c) to restore some credibility to offset the Fed’s extraordinarily loose monetary policy. Her comments surprised markets because they were more hawkish than investors were expecting but there is still a lot of uncharted road between here and the Fed’s next rate hike.
- Fed Chair Yellen re-emphasized the importance of inflation when setting interest-rate policy: ”If inflation is persistently running below our 2 per cent objective, that is a very good reason to hold the funds rate at its present range for longer." There was also no further mention of allowing above-target inflation over the short term. This was significant because inflation has taken a back seat to the health of the unemployment rate and job market indicators since the start of the Great Recession. Expect markets to place more emphasis on the U.S. inflation data going forward.
So we have BoC Governor Poloz forecasting a very subdued Canadian interest-rate environment at the same time as U.S. Fed Chair Yellen hints that the Fed may start raising rates earlier than the markets have been expecting. Here are the direct implications for fixed and variable-mortgage rates:
- Fixed rates: Given that there has been a 90% plus correlation between U.S. and Canadian bond yields since the start of the Great Recession, the Fed’s plans will clearly impact Canadian bond yields, and by association, our fixed mortgage rates. True to form, U.S. bond yields surged higher after the Fed’s press conference and took Government of Canada (GoC) bond yields along for the ride.
- Variable rates: BoC Governor Poloz has recently reassured us that overnight rate increases are still a ways off, that a rate cut is not out of the question, and that the next tightening cycle, when it does arrive, should come with fewer increases than we have seen historically. Most interestingly, it now appears that the BoC’s first rate increase could lag the U.S. Fed’s first rate increase by a significant margin. Interestingly, it wasn’t too long ago that many observers thought that the main factor holding the BoC back from hiking rates was the 0% U.S. federal funds rate (because of the interconnectedness of our monetary policies).
Five-year GoC bond yields rose by thirteen basis points last week, closing at 1.74% on Friday. Despite this spike in yields, market fixed rates are still available in the 3.04% to 2.94% range, and pre-approvals can be had for rates as low as 3.09%. For now. With bond yields on an upward march, anyone who may be in the market for a fixed-rate mortgage sometime soon is well advised to lock in a pre-approval at today’s rates while they still can.
Five-year variable-rate mortgages are offered at rates as low as prime minus 0.65%, which works out to 2.35% using today’s prime rate of 3.00%.
The Bottom Line: U.S Fed Chair Yellen’s comments have fuelled a rise in bond yields that may well push our fixed-mortgage rates higher over the short term. Meanwhile, Governor Poloz’s comments provided reassurance that the BoC’s overnight rate, and by association, our variable-mortgage rates, shouldn’t be heading higher for some time yet.
David Larock is an independent mortgage planner and industry insider specializing in helping clients purchase, refinance or renew their mortgages. David's posts appear weekly on this blog (movesmartly.com) and on his own blog integratedmortgageplanners.com/blog). Email Dave