Having spent 15 years working in capital markets with foreign exchange and interest rates derivatives, prior to becoming a mortgage broker and financial advisor, I have extensive experience assessing what the market is telling us about the future direction of interest rates.
Today (March 29th, 2022) the Bank of Canada’s overnight rate is 0.5% and a 5-year government of Canada bond is trading around 2.50%. The difference between these rates tells us that the market expects the overnight rate to be 2.00% higher than today’s 0.5% overnight rate over the next 5 years.
Today, in choosing between a fixed and variable rate mortgage options, borrowers should add 2% to their variable rate to see what they can expect to pay over the next 5 years. The best 5-year variable rates available in the market today is 1.40% and the best fixed rates are 3.54%.
By adding the 200-basis point (2%) of tightening priced into the bond market over the next 5 years, we can see that clients can expect to pay 3.40% by choosing variable. Borrowers are effectively being “paid” 0.14% each year to stay variable, which works out to 0.7% over the 5-year term of the mortgage (or $3500 on a $500,000 mortgage).
By staying variable, borrowers will also 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. Since 60-70% of borrowers will refinance or sell before the end of their 5-year term, and pay a penalty, it’s important to add the expected cost of the IRD penalty to the fixed rate mortgage.
Again, fixed rates mortgages are generally a terrible choice in Canada because borrowers pay a rate premium (described above) and the fact that 60-70% of fixed rate borrowers also pay a significant interest rate differential penalty for the “certainty” of a fixed rate when they refinance before the end of their term.
Looking closer at the Canadian the bond market, we can also get a prediction of when interest rates will increase.
A 1-year government of Canada bond is trading at 1.88%, implying the overnight rate will be higher on average by 1.38% (1.88% minus 0.5% overnight rate) over the next year, and 1.88% higher (2.38% minus 0.5%) over the next 2 years. The implication is that for the second-year, rates are expected to be 2.38% higher than they are today, which implied an overnight rate of close to 3%. In short, the market is now anticipating about 10 rate hikes over the next year or two.
After 2 years, the market is pricing rates to decrease slightly but for the overnight rate to generally remain from 2.50-2.75% through 2024-2026.
In the last 20 years, there have been 3 tightening cycles from the Bank of Canada.
From July 2004 to July 2007, the BoC raised rates by 2.5% (10* 0.25%)
From May 2010 to September 2010 the BoC hiked 0.75% (3*0.25%)
From July 2017 to Oct 2018 the BoC hiked 1.25% (5 *0.25%)
The tightening cycle in 2004-2007 was the last time the Bank of Canada increased rates by 2.5%, and coincided with tighter financial conditions around the world, and quickly led the Global Financial Crisis.
The 2010 and 2017/18 tightening cycles hiked rates a grand total of 3 and 5 times, in a Canadian economy that had much less debt than today. Today, each rate hike is going to have a much more significant impact, slowing the debt fueled Canadian economy than a rate hike of 5 or 10 years ago.
I expect we will see between 3-5 rates hikes in this cycle, which is consistent with recent history of tightening cycles by the Bank of Canada. You should not lock in your mortgage rate.
But 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.