A single weed can produce as many as 250,000 seeds. If you see one, you’ve got to pull the little sucker before it gets big, spreads and takes over your garden.
Canada’s economy has a bad weed growing in it. It’s called inflation, and our central bank hasn’t pulled it fast enough.
History has shown time and again that if you don’t snip high inflation before it blooms, it takes far more effort to eradicate.
In the last six weeks, the market has awoken to this reality. Fear that the BoC is too late has investors pricing in rapid rate hikes through next year.
But that’s not all.
“…Aspects of current market pricing are sending an ominous warning (i.e. policy error)…” writes Jason Daw, Head of North American Rates Strategy at RBC Dominion Securities.
“…After a fast burst of tightening, the market believes the growth environment will be impaired enough to require rate cuts,” Daw added. “[Yield curve] inversions are rare and this has never happened so early in a hiking cycle…More worryingly, it started well before the first Fed hike.”
For someone choosing a new mortgage today, what that means is that rates could potentially exceed expectations, and then drift lower in the latter half of a five-year term. (That’s assuming you give weight to market expectations, which are always a moving target.)
Interestingly, history shows that one year after central banks start hiking, terminal rate expectations (the market’s forecasts for how high rates could go) usually don’t change much. You can see that in the below chart from RBCDS.
Terminal Rate Expectations
For that reason, there’s a good chance the market will keep expecting at least 200+ basis points in total rate hikes at this time next year.
If you want to play those odds and use them as the basis for mortgage term selection, you might assume that rates will top out roughly 200 bps higher, and then start reverting lower (by 100+ bps?) sometime in 2024.
If you simultaneously assumed that our overnight rate wouldn’t breach the BoC’s mid-point neutral rate estimate (2.25%), you’d find that floating rates can still have a slight edge.
But those are a lot of assumptions.
Whenever you model fixed vs. variable, the results are obviously heavily dependent on when you assume hikes and cuts will occur, and how many you project.
We All Love Variables But…
Students of inflation will tell you that when inflation goes vertical and central banks remove the punch bowl too late, rate-hike cycles last longer and go higher. That can easily result in 18 to 24-plus months of rate hikes followed by another year or more until inflation reverts to its mean. The BoC would likely keep hiking as long as inflation projects above 2.50% year-over-year, despite the risk of recession.
If Canada’s overnight rate lingers above the BoC’s 2.25% neutral rate for more than a few quarters, variable rates will almost certainly cost more, based simply on five-year interest cost.
So, as mortgage professionals whose duty is assuring product suitability, it’s essential to manage risk for vulnerable and/or risk-averse clients.
A borrower who can’t afford to consistently save for retirement, for example, has no business in a fully variable mortgage. Nor does a borrower without significant fallback assets.
And as brokers, we can’t get caught up in fixed-rate IRD penalties being too high. That simply isn’t a threat with all lenders, let alone in a rising-rate market when IRDs shrink.
No one knows what next year will bring, but we do know one thing. Rate risk is no joke to homeowners with tight finances, especially when inflation expectations become unanchored. And there is no question that they already have.