Rate Surveillance: Yields Drop, Forecasts Drop, Rates Barely

It got sort of ugly out there this week. Oil prices sank to dozen-year lows, swap rates (which guide fixed mortgage rates) fell to record depths and stocks tanked, before eventually recovering.

Often times, market action like this leads to cheaper mortgages. But these days lenders aren’t about to drop their pants on rates. They have other problems. Investors are getting scared.

Check out this measure of credit risk in the interest rate market (see chart). The market is forcing even creditworthy borrowers to pay more for capital, and Canadian banks aren’t immune. Banks also face the prospect of lower rates in general (the lower rates go, the less banks make) and higher government-imposed costs related to mortgages.

In fact, banks—which fund most of Canada’s mortgage market—have profit threats coming from every direction. Few of us are inclined to shed a tear for their earnings plight, but we have to acknowledge that market conditions are not as lender-friendly as they used to be. That’s why, in spite of the downtrend in global interest rates, the best fixed mortgage rates have dropped just 0.10 to 0.15 percentage points (pp) from their winter highs.

On a cheerier note (for borrowers, not the economy), we may indeed see more discounting headed into the notoriously competitive March market. At this moment, mortgage margins are big enough to give a little back to consumers. Take the spread (difference) between a typical 5-year fixed rate and the 5-year government bond yield, for example. Right now it’s 2.10 pp. “Normal” is closer to 1.75 pp (note, that “normal” has risen 0.30+ pp in the last few years). Note: “Discounting” in this context means lenders may mark up mortgages less, not necessarily that rates will fall. There’s a difference.

Nevertheless, with today’s best 5-year fixed rates just 0.07 to 0.15 pp off their all-time lows, mortgage shoppers so inclined can confidently lock in without fear of what they might be leaving on the table come March.

Ever-Changing Rate Forecasts

From the FWIW file, Big Banks have once again reset their crystal ball for interest rates.

“We admit to sounding like a broken record when saying that we’ve once again downgraded our near-term bond yield forecasts,” said CIBC World Markets recently. Really? I’d say they sound more like a punctured tire than a broken record. But that’s just me.

The consensus now among Canada’s big banks is for the Bank of Canada’s (BoC’s) key rate to end 2016 unchanged at 0.50%, and then tick up just 0.25 to 0.50 pp in 2017. If they’re right (this time), that implies a https://www.ratespy.com/prime-rate-canadaprime rate no higher than 3.20% in a few years.

But BMO, for one, has other ideas. “After likely cutting rates in April [to 0.25%], we look for the Bank to remain on hold until deep into 2017,” it wrote, adding its expects puny economic growth of just 1.0% in 2016.

Citi economist Ebrahim Rahbari is even less optimistic.  He’s thinking Canada could introduce negative rates within two years, per the Financial Post. By the way, this is one of dozens of negative interest rates stories since December. As this Google Trends report illustrates, all of a sudden, people can’t stop talking about sub-zero interest rates.

We can’t help but wonder if all this negative interest rate talk might actually be a self-fulfilling prophecy. As a big investor, why not jump on 1/2% yields today “before they’re gone?” As a big corporation, why invest in growth (and issue debt at today’s “high” rates) given such gloom. There’s more than a modicum of that logic in today’s market, which could push down rates further.

Against this context, banks have again slashed 5-year government bond yield predictions (like swap rates, government yields lead 5-year fixed mortgage rates). Here’s where economists are throwing their darts now:

U.S. & Canadian Rates Take the Fork in the Road

With our economy stuck in first gear, and with a risk of it sliding into reverse, North American rates have taken different paths. (Canadian rates are normally highly correlated with U.S. rates.)

This U.S./Canadian yield comparison illustrates that divergence clearly.

Despite all the Yellen-isms about “gradual” rate hikes south of the border, that medicine (if administered by the BoC) would only make Canada’s economy sicker.

The Takeaway

Despite our perpetually optimistic central bank governor, and despite all the rate hike chatter coming from the U.S. Federal Reserve, until the 5-year Canadian yield closes definitively above 1.20%, we likely won’t be joining the “rates can’t stay this low” chorus.

For as far as the eye can see—which admittedly isn’t that far—there are no inflation boogeymen to haunt us long-term. Short-term, maybe (see Cauliflower prices). Long-term, no.

So, what does all this mean for mortgage term selection? It means that well-qualified borrowers should continue to find outperformance in shorter contracts.

With that in mind, below is the Spy’s take on each mortgage term…in two lines or less :

• 1-year fixed: Love ’em. The lowest rates in the market. Just be sure your mortgage is big enough to justify the switching costs if your one-year fixed lender gives you a crummy renewal offer in 12 months.
• 2-year fixed: Still have delicious rates, with less renewal hassle than a one-year. The best deuces feature no-fee blending and extending (in case you see a long-term fixed rate that you just can’t resist).
• 3-year fixed: You won’t find a better compromise between interest savings and security today.
• 4-year fixed: Quads are garbagio at today’s rates. They offer little value over 3- and 5-year rates.
• 5-year fixed: If you crave rate certainty and snare a deal (e.g., a 5-year under 2.50%), they’re a satisfactory conservative play. But think in terms of “breakeven rate.” If you pay 0.50 to 0.60 pp more than a 3-year, that’s probably too expensive.
• 7-year fixed:  Don’t be silly.
• 10-year fixed:  Don’t be sillier.
• 3-year variable:  Cheaper than a 5-year variable. If you’re dead set on going variable, why pay more? Variable discounts are cyclical and will hopefully improve when people renew in three years.
• 5-year variable:  At major bank rates, the risk/reward is so-so at best—especially since we can’t expect any more prime rate love from the Big 6. But if you can find a variable at prime – 0.60% or better (I’ll give you one hint where to look), and it’s got just a 3-month interest penalty, that’s not so bad.
• HELOCs:  Unless you have no better option, don’t borrow from a revolving line of credit unless you plan to pay it off in less than a year.
• Hybrid:  Hybrids used to steal our hearts, but what started as a love affair has ended in divorce. It’s mainly big lenders who offer them, and big lenders have pushed hybrid rates above most 5-year fixeds. So what’s the point?