Variable Rates Beat Fixed Rates…A Lot

The foundation for all Canadian interest rates is the overnight target rate. It’s been stuck at or below 1% for an incredible eight years.

That’s never happened before.

We’re living in bizarro economic times and those with big mortgages are hoping they’ll last.

But inflation, the key interest rate driver, is not down for the count. As sure as the Maple Leafs will disappoint us again, core inflation will ultimately remind us that, yes, it can exceed the Bank of Canada’s 3% tolerance.

Will it happen this year? Not a chance (okay maybe a tiny chance).

But once that threat does become real, the Bank of Canada will rush like an addict on free needle day to lift rates. And everyone will be asking the same questions when they do: how many increases, and how fast?

History is a Guide…Sort of

Investment disclaimers always say, “Past performance may not be indicative of future results.”

But the past does provide a sense for what could happen, and history is unambiguous about one thing: rate spikes lack stamina.

Since the 1980s, every time rates have surged, they haven’t stayed high for long. Case in point is this chart:

This graph depicts the largest rate hike we’ve ever seen in the modern era of monetary policy (i.e., since the Bank of Canada started inflation targeting).

In 1994, Canada’s overnight rate rocketed over 450 bps in just one year. If that type of eruption happened today, people would be leaping from their overpriced condo balconies.

But notice that it took only 20 months for rates to once again make new lows.

There have been four other rate spikes of note since inflation targeting began, and none of them lasted much longer. In fact, if you back-tested today’s level of mortgage discounting, and looked all the way back to 1991, you wouldn’t find a single case where the best 5-year fixed rate beat the best variable rate. (Albeit, if you ran this test with more typical rates you’d find several cases where a 5-fixed outperformed.)

Note: We ran this analysis this by comparing a discount 5-year fixed (i.e., one that was 150 bps over the 5-year bond) to the average variable rate over the following five years, based on prime – 0.70%. Obviously this isn’t scientific, mainly because of the sample size, the fact that rates have been downtrending long-term, and because discounts were never this big in prior decades. But discounts should stay in this ballpark or better going forward—barring further government changes.

Noted Professor Moshe Milevsky did a similar study in which he backtested large discounts on historical data. He found that variables win roughly three-quarters of the time. Although his research relied on rates that are higher and less realistic in today market.)

The Moral

Variable rates aren’t as risky as many think; at least they haven’t been in the past.

You could have taken a variable rate at almost any point during the biggest rate increases of the modern era—and still saved more than a 5-year fixed.

Long-term deflationary trends and debt-gorged consumers (who can’t spend as much as they used to) also favour a floating rate strategy. The lower inflation remains, the less chance the BoC will take away the low-rate punch bowl.

Of course, the fact that people think rates will stay low is not a reliable reason to go variable. Predicting rates is like predicting the path of a drunk chicken (or even a sober chicken for that matter). If you’re right, you’re probably just lucky.

The four best reasons to choose a variable boil down to these:

1. you have the financial cushion to withstand higher interest costs
2. you have the discipline to ignore headlines about coming rate hikes
3. you prefer a mortgage with a cheap prepayment penalty, and
4. you have confidence that variable’s historic outperformance will persist (in general, over time).

If you check these boxes above, a variable just may be your ticket.