Five Key Mortgage-Rate Related Thoughts

All Canadian mortgage rates moved higher last week.

Fixed mortgage rates continued to follow the dramatic run-up in Government of Canada (GoC) bond yields, which have reached new post-pandemic highs.

Variable mortgage rates also increased when lenders raised their prime rates in response to the Bank of Canada’s (BoC) 0.25% rate hike on June 7.

Here are five key observations relating to today’s mortgage rates and the factors that are impacting them:

1. US inflation is still looking sticky.

Last Tuesday we learned that the US Consumer Price Index (CPI) fell to 4.0% in May on an annualized basis, down from 4.9% in April. That result was a little below the consensus forecast of 4.1% and marked its lowest level in more than two years.

At this point you might be wondering why that news didn’t excite financial markets.

That’s because the big drop in overall US CPI was overshadowed by less encouraging news about US core CPI. (The Fed believes that core CPI is a better measure of ‘real’ inflation because it strips out food and energy prices, which can be quite volatile – although interestingly, both categories are pulling the overall CPI down right now.)

US core CPI fell to 5.3% in May on an annualized basis, down from 5.5% in April, but mostly because of base effects, which occur when comparatively higher prices from last year roll out of the data set.

US core CPI rose by 0.4% on a month-over-month basis in May, marking the sixth month in a row that it rose by 0.4% or more. Those consistent and hefty monthly increases are proof that core CPI continues to be sticky. That reality is underpinning the higher-for-longer view, which the bond market is now pricing in.

2. The US Federal Reserve’s pause

Last Wednesday, the US Federal Reserve announced that it would hold its policy rate steady for the first time in eleven meetings, but at his accompanying press conference, Fed Chair Powell warned that “nearly all Committee participants view it as likely that some further rate increases will be appropriate this year”.

The Fed’s dot plot, which summarizes each individual Fed official’s forecast of where the policy rate is headed, now indicates that its members expect an average of two more 0.25% hikes by the end of 2023.

Financial markets didn’t get too excited about news of the pause because it related to just one meeting and was not a signal that the Fed’s policy rate had now peaked.

But not everyone is convinced those future hikes will materialize.

Economist David Rosenberg recently explained that using hawkish language when announcing a pause is straight out of the Fed’s handbook. US financial markets have rallied hard on past pauses and the Fed doesn’t want to stimulate those markets when it needs to cool the economy. He also reminded us that the Fed’s dot plot has not been a reliable indicator of where the Fed’s policy rate is headed in the past.

The US economy is clearly slowing, but the questions about whether the process is happening fast enough to keep inflation on a downward trajectory and to keep inflation expectations anchored are still unanswered.

The Fed just bought itself six weeks to observe more incoming data. (Its next meeting will take place on July 26.)

3. The last BoC rate hike punched above its weight.

The most recent hike tightened the tourniquet on Canadian variable-rate borrowers, but most of them have mortgages that come with fixed payments, which don’t increase when their rate rises. (In such cases, the portion of the payment that goes toward the principal decreases, and the portion that goes toward interest increases.)

Our fixed mortgage rates experienced a much more significant impact.

The BoC’s decision to abandon their pause pushed bond yields higher and reinforced their upward momentum. In a matter of weeks, bond-market investors have gone from pricing in imminent rate cuts to betting on another hike before the year is out. That swing has pushed fixed mortgage rates up by 0.50% (or in some cases more).

The latest hike, and the prospect of further ones, has also shaken the confidence of home buyers, who had been showing up in droves at offer nights. It appears to have sharply slowed momentum across our regional real-estate markets.

4. Personal pandemic cash reserves are dwindling (fast).

The excess savings that built up during the pandemic created a buffer that has allowed consumers to absorb higher prices without having to reduce their spending. But those savings are being rapidly depleted for an increasing number of households.

Credit card and unsecured line-of-credit utilization rates are rising, and credit default rates, although still low by historical standards, are also increasing.

When the pandemic-savings buffer fades, our economy should look more like what you would expect to see after the sharpest series of rate hikes on modern record have been applied to record-high debt levels.

5. The looming mortgage-rate shock in 2025 probably keeps our policy makers up at night.

The BoC estimates that it can take up to two years for its rate hikes to exert their full economic impact, but in the current context, it may take even longer than that because of a looming vulnerability that was largely of the BoC’s own making.

In 2020 when GoC Governor Tiff Macklem promised Canadians that they could count on rates staying low for an extended period, Canadians piled into five-year variable-rate mortgages that started in the 1.5% range.

Most of those mortgages came with the fixed payments I highlighted in point #3 above. When they reach the point where the minimum payment is no longer covering the interest cost, the payments are supposed to be reset based on current rates (which is referred to as the “trigger reset”).

But for the most part, trigger resets haven’t been fully applied. Instead, lenders have offered borrowers more flexible options.

These include allowing borrowers to increase their payments by only enough to cover the interest portion of the payments based on current rates, or allowing them to keep their payments unchanged, even though they are no longer covering the interest cost, and adding the shortfalls onto the mortgage principal (when there is enough equity to do so).

That flexibility has given mortgagors a temporary reprieve from higher rates. But when the 2020 vintage of fixed-payment variable-rate mortgages come up for renewal in 2025, the payments will have to be reset using whatever rates are available at that time. If today’s rates hold, that would result in a near doubling of the required payments for a large swatch of borrowers.

Of course, if inflation cools sufficiently there will be room for rate cuts before then. If the BoC needs any more reasons to ease up on rates as soon as possible, they can add limiting the impact from a mess of their own making to the list.

The Bottom Line: Lenders continued to raise their fixed mortgage rates last week to keep up with spiking GoC bond yields. Both have now risen to new post-pandemic highs.

Meanwhile, variable-rate borrowers face the prospect of an additional hike before the year’s end.

If you are looking for a silver lining, I think the higher rates go, the more they will hasten the arrival, and the extent, of rate cuts that will eventually follow. More pain now should mean less pain later.  

David Larock is an independent full-time mortgage broker and industry insider who works with Canadian borrowers from coast to coast. David's posts appear on Mondays on this blog, Move Smartly, and on his blog, Integrated Mortgage Planners/blog.

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