Yesterday (June 1, 2022) the Bank of Canada’s raised its overnight rate by 0.5% to 1.25% and 5-year government of Canada bonds are now yielding around 2.95% up from around 2.65% prior to their announcement.  The 50-basis point increase from the Bank of Canada was widely expected by the market, so what has changed causing bond yields to move higher?

The most important change from the Bank of Canada yesterday is found in the last sentence of their policy announcement “the Governing Council is prepared to act more forcefully if needed to meet its commitment to achieve the 2% inflation target.” The addition of this sentence leads the market to believe additional rate hikes will be used to reduce inflation and inflation expectations going forward.

Credibility is a very real issue for the Bank of Canada. Inflation is now running well above the Bank’s 1-3% target.  Inflation has stayed within this target range since inflation targets were announced in 90’s, until last year when inflation began to move higher.  Today, headline inflation running at 6.8% annually, with the Bank of Canada’s core measures of inflation ranging between 3.2% and 5.1%

Rate Forecast

Many, including myself, are scratching their head to understand why the Bank of Canada didn’t start raising rates sooner.  Inflation has been directly caused by the Bank of Canada’s quantitative easy policy and been supported by global supply chain issues.  Inflation has been running well above the Bank of Canada’s target for over a year.

By raising rates and reducing demand (a direct result of increased debt service costs) the Bank of Canada has the tools they need to bring inflation back in line.  With debt at record levels in Canada, higher interest rates will quickly feed through to less consumer spending, decreased housing affordability, and soon the secondary effects of a sharp slowdown in real estate activity seen in the last 3-4 months.

If there is anything I’ve learned from trading bonds for 15 years, is that interest rates can stay lower for longer than the market is predicting.  I agree that we are seeing unprecedented levels of inflation. I also believe with Canada’s unprecedented government and consumer debt levels it won’t take many more rate hikes to reduce inflation, and inflation expectation, sharply.

House prices in the GTA are already 10-20% lower than their mid February peaks, and activity levels have fallen significantly.  The biggest risk to the housing market is prices rolling negative y/y, at which point short term “B” and “private” mortgages will come due for homeowners who will not have enough equity to renew.  Some homeowners will be forced to sell. (a topic for another day)

My advice remains, by staying variable borrowers will avoid the huge interest rate differential penalties that come with fixed rate mortgages in Canada if they refinance or sell before the end of their term and 60-70% of borrowers will refinance or sell before the end of their 5-year term.

From a rates perspective, it seems highly unlikely that we see the next 7 rate hikes that the bond market is predicting.  A fixed rate mortgage lets you lock into payment based on rates already being hiked 7 times.  My expectation is that the rate hikes will be unwound as a slowdown in the real economy begins to show up in the data very soon if it isn’t already.

If you have questions about your personal situation and options, and are looking to save money on a mortgage, or use your mortgage to reduce your taxes, I can help.                 416-769-1440