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.
The U.S. employment data for June came in much higher than expected as the U.S. economy added 288,000 new jobs for the month.
The evolving U.S. labour market continues to present a vexing challenge for market watchers.
On the one hand, the U.S. economy has added at least 200,000 new jobs for five months in a row, for the first time in fifteen years. The unemployment rate fell to 6.1%, which is the lowest it has been since late 2008, and unlike in past reports, this drop was not caused by more Americans withdrawing from the labour force.
On the other hand, the U-6 rate, which is a broader measure of unemployment, was unchanged and remains elevated at 12.4%. Furthermore, while many new jobs have technically been added to the U.S. economy, as has so often been the case lately, almost all were in part-time positions and many were in the retail and leisure/hospitality sectors, which tend to be lower paying. And more importantly, the number of formerly full-time employees who were unwillingly changed to part time status is almost as large as the number of new jobs created.
Thus, we are left to debate which trend will win out. Will today’s U.S. employment momentum fuel higher-than-expected wage inflation that will surprise the U.S. Federal Reserve and force it to tighten U.S. monetary policy more quickly than planned? Or will the continued creation of these ‘McJobs’ undermine the purchasing power of American consumers, whose average incomes are barely keeping pace with official U.S. inflation (to say nothing of real inflation!)
I think we are now approaching a significant turning point in market sentiment. Those who argue that the U.S. employment picture is improving rightly point out that wage growth always lags the economic cycle. As such, anyone relying on rising U.S. labour costs as a gauge for overall inflation momentum is in danger of being behind the curve when the interest-rate tide turns. Market watchers who are also students of history know that the U.S. Fed almost always waits too long when timing directional changes in its monetary policy. And that is using more ‘normal’ examples of monetary policy, not the unprecedented levels of monetary-policy stimulus that we see the Fed engaged in today.
The other key point to remember as we parse the latest U.S. employment data is that markets are made at the margin. Many investors are less concerned with the overall health of the U.S. economy than they are with incremental signs of change when altering their portfolio mixes. As such, while we may still be a long way from seeing the overall U.S. economy return to its former definition of health, we cannot ignore the U.S. employment market’s gathering momentum, warts and all.
So what does this mean for Canadian mortgage borrowers?
Interestingly, since the start of the Great Recession most market watchers (me included) have argued that the U.S Federal Reserve’s ultra-low policy rate was preventing the Bank of Canada (BoC) from raising its overnight rate, when it might otherwise have done so. Given the interconnectedness of our economies, this would have caused the Loonie to appreciate further against the Greenback, thus creating a further drag in momentum for our already beleaguered export-based manufacturers. But since U.S. economic growth is now outpacing our own, most experts have altered their view and think the BoC will end up lagging the Fed when it eventually starts to tighten U.S. monetary policy.
Nevertheless, the spread between our five-year fixed and variable mortgage rates remains quite narrow, at about 0.60% today, and that doesn’t give our variable-rate borrowers very much ‘margin of safety’ for whenever the BoC starts to raise its overnight rate (even when we remember that the BoC Governor Poloz has said that the Bank will tighten more slowly than it has done in the past). As such, when asked for my two cents I am now recommending five-year fixed rates over variable rates for most borrowers in the current environment.
The tougher question to answer is how borrowers who already have variable-rate mortgages, many of them more deeply discounted than those available to new borrowers today, should respond to the recent changes in U.S. economic momentum. The answer to this question is not unanimous because even most observers who think U.S. interest rates will rise more quickly than the Fed is predicting still think we are at least a year away from the first Fed policy-rate increase. As such, variable-rate borrowers who are more than half way through their five-year term still have time to bank more interest-rate saving in the meantime.
In doing so, they will probably have to summon their courage to stay the course.
That’s because fixed-mortgage rates, which act as the conversion safety net for variable-rate borrowers, are likely to rise first since they are tied to longer-term bond yields, which are more sensitive to changes in medium- and long-term inflation expectations. If the Canadian employment data for June surprise to the high side when they are released this Friday, as some are predicting they might, we could easily see fixed mortgage rates spike very soon.
Five-year Government of Canada bond yields rose five basis points last week, closing at 1.61% on Friday. Five-year fixed-rate mortgages are available in the 2.84% to 2.99% range and five-year fixed-rate pre-approvals are offered at rates as low as 2.99%. Anyone who is in the market for a fixed-rate mortgage is well advised to lock in a pre-approval in advance of Stats Can’s release of the employment data this Friday for the reasons listed above.
Five-year variable-rate mortgages are available in the prime minus 0.65% range, which works out to 2.35% using today’s prime rate of 3.00%. Well-qualified borrowers who know where to look may even be able to do a little better than that.
The Bottom Line: While I think that the U.S. economy’s long-term recovery is still an open question, there have been enough incrementally positive changes in the U.S. economic data to put upward pressure on U.S. and Canadian bond yields over the short term. In addition, given the unusually narrow spread between our five-year fixed and variable mortgage rates today, this expected near-term momentum bolsters my existing view that five-year fixed rates are the better option for most borrowers in the current environment.
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