The Tug of War Between Trade Uncertainty and the Energy Shock

Last week our latest Canadian employment data confirmed that our economy created 14,000 new jobs in
March. That was a welcome change from 110,000 jobs lost in January and February, but it’s hard to get too
excited about that uptick.

Canadian consumer confidence is now at an eleven-month low, weighed down by concerns about the near-term impacts of the energy shock and the long-term impacts of trade uncertainty.

We also received the latest US inflation data. It showed a sharp increase in the US Consumer Price Index (CPI), which rose from 2.4% in February to 3.3% in March on an annualized basis. Most of that spike was driven by surging gas prices, which was expected.

The most important detail for policy makers and bond-market investors going forward is how much higher energy prices will impact prices in the broader economy.

Central bankers can look through an energy-price spike if they see it as temporary, and they typically do. US Fed Chair Jerome Powell recently noted that “energy shocks have tended to come and go pretty quickly” and that “by the time the effects of tightening take effect, the oil price shock is probably long gone.”

But central banks will be compelled to act if higher energy prices cause inflation to accelerate more broadly and/or cause inflation expectations to change.

Thus far at least, there is little evidence of that occurring.

US core inflation, which strips out our food and energy prices, increased from 2.5% in February to 2.6% in March (annualized), less than the consensus expected.

That said, we learned over the weekend that the attempt at peace negotiations between the US and Iran ended without a resolution, and that the US will now also block ships leaving Iran from passing through the Strait of Hormuz. Iran continues to threaten the safe passage of ships originating from other countries through the Strait, so the flow of ship traffic is now even more restricted.

Oil prices have already surged higher again in response, and with no end of the conflict in sight, they will have more time to exert their inflationary impact.

While an inflation spike similar to the one we experienced at the end of COVID may now seem evitable, it isn’t.

Consumers can’t substitute away from higher energy prices. They will have to reduce spending in other areas instead. The longer-term inflationary impact of higher energy prices will also be slower to spread because the demand for labour is now much weaker than it was during COVID.

That gives workers much less leverage to push for wage increases to offset higher costs.

Neither do we have ultra-low interest rates stimulating demand this time around. Instead, bond yields, and the interest rates that are priced on them, have surged higher alongside energy prices. Higher borrowing costs reduce demand in ways that are similar to monetary-policy tightening (and as such, they reduce the need for central banks to hike their policy rates).

We also don’t have COVID-relief measures providing extraordinary stimulus to consumers this time around. The excess liquidity that was sloshing around in our economies helped to super-charge inflation back then.

In summary, the longer the Middle East conflict drags on, the greater the likelihood that higher energy prices will trigger broader inflation. But that process will take time to play out and, thus far, the US Fed and the Bank of Canada (BoC) don’t see it as their base-case scenarios.

The Latest on Mortgage Rates

Government of Canada (GoC) bond yields remained volatile last week and finished the week a little lower than where they started.

Fixed mortgage rates have stabilized for the time being, but borrowers should expect more volatility ahead.

Variable-rate discounts also held steady last week.

Two weeks ago, I wrote that bond-market investors were probably getting ahead of themselves. Since then, the bond-futures market has reduced its bet on BoC policy-rate hikes in 2026 from 0.75% to 0.50%.

In my estimation, the bond-market is currently pricing in worst-case scenarios that are far from guaranteed, perhaps, in part, due to COVID-related recency bias.

For now, I maintain my contrarian call that the Bank’s next eventual move will be a cut, because I expect the deflationary impacts from trade realignment to outlast the inflationary impacts from the current energy shock.

My Take on Today’s Mortgage Options

Fixed rates continue to rise. Anyone who is actively looking to purchase within the next 120 days should lock in a pre-approval rate now.

Three- and five-year fixed rates remain the most popular choices. If the spread between those two options is minimal, I think five-year fixed rates offer better value.

Most of the borrowers I am working with right now are opting for the stability of fixed rates, and I fully appreciate their appeal.

That said, the relative saving offered by today’s variable rates has increased now that spiking bond yields are putting significant near-term pressure on fixed mortgage rates.

I continue to believe that variable mortgage rates will produce the lowest borrowing cost over their full terms, although the potential that they will take borrowers on a bumpy ride has increased since the start of the US/Iran war.

BoC Governor Macklem confirmed that the Bank will look through the oil-price spike over the near term. But if the war drags on and the inflationary impact from higher oil prices becomes more entrenched, there will come a time when the Bank must tighten.

For now, my assessment is that we won’t get to that point. But so much depends on how long the US/Iran war will last and if/when the Strait of Hormuz will re-open – and that is anybody’s guess at this point.

Important note: Anyone choosing a variable rate should do so only if they are comfortable with its inherent potential for volatility. Borrowers must also have the financial capacity to withstand higher costs (and in some cases, higher payments).

Insider’s Tip for Borrowers

If you’re in the market for a mortgage, instead of focusing on how much you can borrow, you will be far better off in the long run by focusing on how much you can (conservatively) afford to pay.

A lender doesn’t care if you ever save for retirement, take a vacation, or go out for a nice dinner. So, when you decide how much you will borrow, focus on what works for your budget, not on the maximum amount you can borrow.

This post offers advice on how to work out a reasonable mortgage budget using two different approaches: the easy way and the hard way.

Three Posts Every New Visitor to My Blog Should Read:

1. Should Canadians Choose a Fixed or Variable Mortgage Rate During a Trade War?

This post provides a detailed comparison of the pros and cons of fixed- and variable-rate mortgages amidst trade-related economic uncertainty. 

2. What Every Canadian Borrower Needs to Know About Fixed-Rate Mortgage Penalties

 For myriad reasons, some of them unanticipated, many Canadians end up having to break their fixed-rate mortgages. This post provides a detailed breakdown of the very different ways that lenders calculate their fixed-rate mortgage penalties. The amounts charged can vary significantly from lender to lender. 

3. What’s in the Fine Print

 This post provides a detailed summary of the key terms and conditions to pay attention to in your mortgage contract. (They are not standard and can vary in important ways.) 

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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