Why Last Week Matters to Future Canadian Mortgage Rates

Dave Larock in Interest Rate UpdateMortgages and Finances

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Today’s post will provide a summary of three notable developments last week that have implications for Canadian mortgage rates.

The Office of the Superintendent of Financial Institutions (OSFI) Proposes Increased Capital Requirements for Mortgage Insurers

Just when you thought that all of the signs pointed toward ultra-low mortgage rates for as far as the eye can see, along comes our banking regulator, OSFI, with a draft proposal that would require mortgage insurers to put up more capital for mortgages deemed to have elevated levels of default risk as of January 1, 2017.

Our regulators are feeling increased pressure to make policy changes to address overheated housing markets, and tightening up capital requirements for our mortgage default insurers seems like a reasonable place to start (given that default insurance is ultimately backed by Canadian taxpayers).

To date, our default insurers (CMHC, Genworth and Canada Guaranty) have charged the same default insurance premiums for mortgages across all regional Canadian markets. But if increased capital requirements for specific high-priced regions, like Toronto and Vancouver, are introduced, one would expect the cost of the premiums in those regions to rise. So, for example, a borrower who is putting down 10% of the purchase price of a home in Toronto might soon pay a higher default-insurance premium than a borrower making the same down payment in Winnipeg.

Most interestingly, this change would apply to both high-ratio loans, where borrowers are putting down less than 20% of the purchase price, and also to conventional loans, where borrowers are making down payments of 20% or more. The latter is significant because today, the lender typically absorbs the default insurance premiums charged on conventional loans. So whereas a lender can pass on increased insurance costs to high-ratio borrowers by bumping their up-front premiums, on conventional loans those increased costs would most likely be absorbed through mortgage-rate increases. Today there is often a small gap between high-ratio and conventional mortgage rates, where high-ratio borrowers gain a slight discount in exchange for paying for high-ratio default insurance, and that gap is likely to grow wider as a by-product of OSFI’s latest proposal.

In addition to higher borrower costs, default insurers are likely to tighten their underwriting guidelines in markets that require increased capital, which means fewer exceptions for marginal borrowers who are just getting under the bar. And this change will hit many of the monoline lenders harder than banks, because the monolines, which specialize in mortgage lending only, typically need to insure all of their conventional loans against default, whereas banks have access to alternative funding sources that don’t require default insurance.

While higher borrowing costs and a tilted playing field that favours certain lenders over others aren’t music to our ears, raising capital requirements to address the significant and rising disparities between our regional housing markets seems like a prudent move. In the long run, changes like this should continue to be good for us, in a brussel sprouts sort of way.

The U.S. Fed’s Latest Announcement

The U.S. Fed met last week and kept its policy rate unchanged, as expected. While the Fed’s accompanying statement was generally upbeat, Fed Chair Yellen’s press conference comments were more cautious.

In its official statement, the Fed observed that the labour market “continued to strengthen”, and economic activity had “picked up”, albeit from a “modest pace in the first half of this year”. Household spending has been “growing strongly” but “business fixed investment has remained soft”. Business spending is key for sustainable long-term economic growth. Near term risks to the economic outlook remain “roughly balanced” and while the Fed believes that “the case for an increase in the federal funds rate has strengthened”, it decided “to wait for further evidence of continued progress toward its objectives”.

Taken on its own, the Fed’s official statement would lead market watchers to believe that higher U.S. interest rates are not that far off. But then Fed Chair Yellen stepped up to the microphone for her Q & A session and her comments sounded much more dovish. For example, she observed that labour-market slack has been taken up “at a somewhat slower pace than in recent years”, and while the Fed had referred to its current policy-rate level as being “highly accommodative” in the past, in her comments last week, Fed Chair Yellen described it as being “moderately accommodative” instead.

On balance, the market deemed the Fed’s latest communication to be a “hawkish hold”, because it left its policy rate unchanged but cautioned that rate increases may not be far off. The market is now pricing roughly 50% odds of a Fed rate hike at its next meeting in December. Given that the Fed must continue to balance between providing policy-rate stimulus to the market and sowing just enough doubt to keep speculators at bay, those odds are probably right about where Fed Chair Yellen wants them.

Bank of Canada (BoC) Governor Poloz’s Latest Speech

We also heard from BoC Governor Poloz last week, in a speech titled “Living with Lower for Longer”, which was not written as a primer on how to keep the pounds off heading into the winter months.

Governor Poloz explained that our aging population has led to “a steady decline in the potential growth rate of the economy”. That, in combination with “rising global savings rates” and moderated global investment spending, has caused “the price of borrowing” to grind “even lower”.

Against this backdrop, Governor Poloz reiterated the BoC’s belief that our economy is facing “strong headwinds” that require “stimulative monetary policy”, but he also noted that the BoC’s current policy rate is “not as stimulative as it would have been before the financial crisis”.

Governor Poloz also observed that companies aren’t investing in capacity expansion and increased hiring because they have “a high level of uncertainty” regarding “future demand prospects” after having “lived through the daunting experience of the financial crisis and Great Recession” and given “all sorts of economic and geopolitical uncertainties across the global economy”. But he also noted that companies were using hurdle rates, which are defined as “the lowest acceptable rate of return that a company chooses for an investment to proceed”, that were not reflective of a lower-for-longer interest-rate environment. In today’s world, he opined, “four per cent will probably turn out to be a pretty good return.”

Governor Poloz explained that the BoC operates today under the assumption that “Canada’s economic potential is likely to grow by only around 1.5 per cent” going forward. In this new normal, he concludes that “ultra-low interest rates are a symptom of the conditions we face” and that “we need to prepare for lower for longer”.

This speech reminded me of my oft-repeated observation that today’s ultra-low interest rates will provide a silver lining in what will otherwise be cloudy economic days ahead.

Five-year Government of Canada bond yields fell twelve basis points last week, closing at 0.62% on Friday. Five-year fixed-rate mortgages are available in the 2.29% to 2.39% range, depending on the terms and conditions that are important to you, and five-year fixed-rate pre-approvals are offered at about 2.49%.

Five-year variable-rate mortgages are available in the prime minus 0.40% to prime minus 0.50% range, which translates into rates of 2.20% to 2.30% using today’s prime rate of 2.70%.

The Bottom Line: The Fed’s decision to hold its policy rate steady and the BoC’s Lower for Longer speech last week left me with the impression that market forces will not be pushing our mortgage rates materially higher any time soon. But OSFI’s draft proposal to increase the capital requirements for our mortgage default insurers means that higher borrowing costs may be on the way regardless. Stay tuned.

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

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