Dave Larock in Interest Rate Update, Mortgages and Finances
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Last Wednesday, the U.S. Federal Reserve voted unanimously to raise its policy rate for the first time in nearly a decade. The reaction in financial markets to this widely anticipated move was initially positive, but the euphoria didn’t last long as investors recalibrated their portfolios to account for tighter U.S. monetary policy and the resulting further appreciation of the world’s reserve currency.
Here are the highlights from the Fed’s accompanying press release:
So what are the implications for Canadian mortgage borrowers? We can’t yet know for certain but the Fed’s move does create some new risk.
If the Fed’s policy rate causes U.S. bond yields to rise, as is expected, our equivalent Government of Canada (GoC) bond yields could well get taken along for the ride. In fact, there has been an almost 100% correlation between changes in U.S. and Canadian bond yields since the start of the Great Recession. If our GoC bond yields rise, our fixed mortgage rates, which are priced on them, will move higher as well.
While there is a good argument that U.S. and Canadian bond yields will decouple, given the divergence in our respective outlooks, the correlation is well entrenched and it’s not a given that this decoupling will happen. I think Bank of Canada (BoC) Governor Poloz was actually trying to encourage the market to think about decoupling when he chose to talk about negative interest rates and his willingness to use unconventional monetary policy just prior to the Fed’s first policy-rate increase. It certainly put the BoC’s current thinking in sharp contrast to the Fed’s evolving view.
The other risk we now face is that the U.S./Canadian exchange rate will widen further. The BoC has supported a weaker Loonie for some time because it views a recovery of our export-manufacturing sector as being a key ingredient in any sustainable Canadian economic recovery. The BoC’s hope is that a cheaper Loonie will fuel export growth which will then lead to increased business investment, starting a cycle where growth fuels investment and vice versa. But there is another risk if our exchange-rate gap grows too wide. For example, a cheaper Loonie increases the cost of our imports, and many of our export manufactures need to import the manufacturing equipment or goods that are used in their manufacturing processes. When the Loonie drops in value, higher import costs must be borne right away, while the benefits of more competitively priced exports will take longer to accrue. The wider the exchange-rate gap becomes, the more short-term pain our manufacturers have to endure before they can eventually benefit from any associated gains (and that assumes they stay in business long enough to see those gains).
Five-year GoC bond yields rose by one basis point last week, closing at 0.75% on Friday. Five-year fixed-rate mortgages are available in the 2.59% to 2.74% range, but several major banks raised their five-year rates to 2.94% last week and other lenders may follow shortly. That said, five-year fixed pre-approval rates are still being offered at rates as low as 2.79% (for now).
Five-year variable-rate mortgages are available in the prime minus 0.50% to prime minus 0.35% range, which translates into rates of 2.20% to 2.35% using today’s prime rate of 2.70%.
The Bottom Line: The U.S. Fed’s policy-rate increase creates the risk that our fixed mortgage rates might rise in the near future if the high correlation between U.S. and Canadian bond yields is sustained. Meanwhile, our variable rates, which are priced on the BoC’s overnight rate, aren’t likely to be affected because the BoC’s current assessment of our economy is far less optimistic than the Fed’s at the present time.
I will be off next week for some family time, but will hit the ground running again on Jan 4. In the meantime, I wish you all a safe and happy holiday season. See you in 2016!
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, Move Smartly, and on his own blog: integratedmortgageplanners.com/blog Email Dave