Three Reasons Why I Think the Market Is Overestimating the Future Path For Canadian Mortgage Rates

Dave Larock in Interest Rate UpdateMortgages and Finances

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Market watchers (and mortgage borrowers) are paying close attention to our economic data after the Bank of Canada (BoC) recently moved off the sidelines and raised its policy rate for the first time in more than seven years.

They are looking for signs that reinforce the view that the BoC will continue to raise rates – and suddenly every positive economic data point is being interpreted as further proof that more near-term rate hikes are inevitable.

If you pick up any newspaper today, you can read arguments in support of this view, so in today’s post I am going to put on my contrarian hat (it’s never too far from reach) and make the case that the consensus is now overestimating the future path for Canadian mortgage rates.  

1. The Latest Retail Sales Data (for May) Are Yesterday’s News

Last week’s retail sales report was interpreted as a bullish signal.              .

Canadian retail sales rose by 0.6% in May, well above the consensus forecast of 0.2% for the month. The rise was largely a result of higher sales at motor vehicle and parts dealers, and the dollar value of our total retail sales came in at $48.9 billion, which marked a record high.

The pundits came out in force to say that the latest retail sales data bolster the case for another BoC rate rise in October, and bluntly put, I found that strange.

From my desk, the May retail sales data validate the BoC’s decision to raise rates in July, but they don’t tell us anything about whether the Bank will do so again later this year.

To cite one obvious example of how our economic circumstances have changed since then, consider that the Loonie was trading at around 73 cents against the Greenback in May, giving our exporters a strong currency tailwind. Last Friday, the Loonie closed at 80 cents versus the Greenback, and May’s tailwind has quickly morphed into July’s headwind.

To put that change in perspective, economist David Rosenberg estimates that the Loonie’s 9.2% jump from its low on May 4 to its close at 80 cents last Friday has had the same economic impact as another 300 basis points (3%) of policy rate rises by the BoC. (Rosenberg used the BoC’s own Monetary Conditions Index measure to make this calculation.)

As I explained in last week’s post, the BoC tends to overestimate the future strength of the Canadian economy when the Loonie is rising. If our economy subsequently underperforms, that underperformance will militate against further near-term policy-rate increases.

While it will take time for the impact of the Loonie’s recent surge to be fully understood, I think the economic data for July and the months that follow will provide much more reliable insight into the BoC’s future plans than the retail numbers for May.

2. The U.S. Federal Reserve Is Becoming More Cautious

The U.S. Federal Reserve meets this week, and while it was once expected to raise its policy rate at this upcoming meeting, the futures market now puts those odds at about 3%. (The futures market is now betting that the Fed won’t raise again until March, 2018.)

Federal Reserve Chair Janet Yellen sounded less convinced that today’s low levels of U.S. inflation will prove transitory when she recently testified before the U.S. Congress, and recent U.S. economic data cast doubt on the strength of current U.S. economic momentum overall.

If the Fed does sound less optimistic about the U.S. economy’s prospects this week, expect the Loonie to surge even higher against the Greenback as a policy-rate gap between the hawkish BoC and the dovish Fed suddenly appears. And if that happens, it will significantly decrease the odds of more BoC rate rises any time soon.

When the Fed started raising its policy rate last year, it gave the BoC some cover to do the same without upsetting the delicate exchange-rate balance between our two countries. But if the Fed adopts a more cautious tone, as I expect it will, financial markets will reprice the U.S. dollar lower and push the Loonie higher as a by-product.

While the BoC has the luxury of lagging the Fed when it increases rates, because doing so weakens the Loonie and helps our critically important exporters in the bargain, it has much less flexibility to delay its response to Fed policy-rate decreases or even to dovish shifts in the Fed’s policy-rate language.

Given that, if the Fed softens its tone this week, keep your eye on the Loonie. If it continues to move higher, Government of Canada (GoC) bond yields should move in the other direction as the odds of more BoC rate hikes diminish.

3. Our Inflation Rate Just Fell (Again)

We received the latest inflation data last week and it showed that our overall Consumer Price Index (CPI) fell to 1.0% in June. In addition, two of the Bank’s three measures of core inflation (CPI common and CPI median) were up 0.1% last month while the other, CPI Trim, remained flat.

The BoC has concluded that our current inflation softness is temporary, and as such, it has expressed a willingness to “look through” the current data. But for how long?

In its latest Monetary Policy Report (MPR) the Bank forecast that overall CPI will rise to 1.6% by the fourth quarter of this year (after revising its previous forecast down from 2.1%), so for anyone keeping score at home, overall CPI inflation will need to rise sharply over the remainder of 2017 for the BoC’s forecast to prove prescient.

In my view, it seems increasingly unlikely that overall inflation will spike from 1.0% to 1.6% at the same time that our economy is experiencing the disinflationary impacts of the soaring Loonie, and especially if average wage growth continues to sputter along. To that end, we’ll get a look at the next round of employment data soon, on August 4.

Five-year GoC bond yields rose one basis point last week, closing at 1.52% on Friday. Five-year fixed-rate mortgages are still available at rates as low as 2.64%, and at rates as low as 2.79% for low-ratio buyers, depending on the size of their down payment and the purchase price of the property. Meanwhile, borrowers who are looking to refinance can find five-year fixed rates in the 2.99% to 3.09% range.

Five-year variable-rate mortgage discounts remain largely unchanged and are still available at rates as low as prime minus 0.90% (2.05% today) for high-ratio buyers, and at rates as low as prime minus 0.75% (2.20% today) for low-ratio buyers, again depending on the size of their down payment and the purchase price of the property. Borrowers who are looking to refinance should be able to find five-year variable rates around the prime minus 0.45% to 0.70% range, which works out to between 2.25% and 2.50% using today’s prime rate of 2.95%.

The Bottom Line: The BoC wants to raise interest rates and it has justified its decision to do so with a set of forecasts about how our economy will progress in future. Those forecasts are based in part on the assumption that the Loonie will trade at an average of 76 cents versus the Greenback (it’s at 80 cents today and climbing) and that inflation will move sharply higher in the months to come.

For the reasons outlined above, I think the accuracy of the BoC’s forecasts is far from certain. And if the BoC is wrong, its actions tomorrow will not match its words today. Food for thought as you scan today’s headlines and read warnings about sharply higher mortgage rates on the horizon.

David Larock is an independent mortgage broker 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: Email Dave 

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