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FedEver since the infamous 2013 Taper Tantrum, we’ve been hearing about impending Fed rate hikes and all of their implications. It was like a giant raincloud following us month after month.

Today, finally, that cloud of uncertainty passed.

A few quick thoughts on the Federal Reserve’s 25-basis-point rate bump:

  • It was built up as a blockbuster rate meeting. Yet, yields closed the day little changed. What we saw was a case of textbook anticipation fatigue, and an announcement that couldn’t have been any more anticlimactic.
  • Our eager economist friends are already predicting what happens next: four more U.S. rate hikes in 2016, they say.
  • Long-term Canadian rates—like the 5-year yield—may somewhat track long-term U.S. rates, but it won’t happen to the same extent it usually does, not with North America’s economies deviating.
  • Short-term Canadian rates (e.g., prime rate) will continue to hinge on domestic inflation data, Bank of Canada-speak, oil prices, and so on. They may increasingly take separate paths from U.S. rates for the foreseeable future. (You can see this divergence already in each country’s 2-year notes.)

In reality, not much has changed on this side of the border, post-Fed-decision. Core inflation is still steady and holding near the Bank of Canada’s 2% target and true inflation is still well below it (says the Bank). With all this Fed “liftoff” distraction out of the way, we can get back to advising clients on what matters most, which doesn’t entail sweating about future interest rates.

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Numerous lenders trimmed their variable-rate discounts last week, lifting rates anywhere from 5 to 15 basis points.

Higher short-term funding costs are largely to blame. Have a look at this chart of 12-month bankers’ acceptances (BAs), which roughly correlate with lenders’ projected funding costs for variable-rate mortgages.

CDOR

BA rates usually rise when traders expect Bank of Canada rate hikes. That’s not the case here. Instead, BAs have risen in the face of higher perceived credit risk. Since August 24, when the Chinese stock market crash rattled financial markets worldwide, the 12-month BA rate is up 10 bps.

Even the 1-month BA, a better reflection of current variable-rate funding costs, is up noticeably since the summer.

1Month-CDOR

On top of general credit spreads, two other factors could be at play:

  • Some lenders may be rebalancing their portfolios after becoming overweighted in variable-rate loans.
  • A few lenders may be suffering from a shortage of short-term deposits (a key mortgage funding source).

Meridian Drops a Rate Bomb

As other lenders were chopping their variable-rate discounts, Ontario’s largest credit union launched a blockbuster VRM sale. Meridian Credit Union, which likes to zig while other lenders zag, is now advertising a spectacular prime — 0.85%. That’s the biggest widely advertised floating-rate discount from any lender in months.

The next best publicly advertised lender-offered rate is 20 bps higher (prime — 0.65%) from Prospera Credit Union, HSBC and Home Trust. Some brokers are discounting even further, with many of them below 2.00% at the moment.

Meridian-Credit-UnionMeridian is selling this 1.85% rate through all of its distribution channels, something brokers will appreciate after being excluded from its epic 1.49% rate sale. But more interesting is the fact that Meridian is securitizing this mortgage, which makes you wonder why other broker channel lenders who securitize are raising their rates.

On the features side, this deal has all the frills:

  • A 20% prepayment option
  • Portability within Ontario (with a 90-day port gap)
  • Ability to lock into a 5-year fixed with no penalty (and Meridian’s conversion rates are actually competitive and transparent, unlike too many other lenders)
  • Skip-a-payment
  • Ability to blend the rate (if you need to add new money)

That last point is key if you ever refinance or move up and need a bigger mortgage. Only a minority of lenders have this feature — i.e., allow you to increase the mortgage while retaining the discount on your existing loan amount.

A few more details:

  • Meridian lets you qualify at the contract rate (currently 1.85%) if you’re a safe credit risk and have at least 20% equity. The vast majority of lenders make you prove you can afford payments based on the posted 5-year rate (4.64% currently). Meridian’s policy is a huge benefit if you’re an otherwise qualified borrower who wants a variable, but have temporarily high debt ratios.
  • Meridian’s maximum GDS/TDS is 34/44 but Meridian may pull back on the loan-to-value if a client is near the limits of those ratios.
  • You must live or work within a reasonable proximity of a Meridian branch.
  • Switches are not available (only refinances and purchases).
  • Meridian will likely be swamped with applications, so don’t expect rapid turnaround and a quick closing.

The one big string attached to this 1.85% rate is that it’s a fully closed mortgage, meaning you have to ride out the 5-year term unless you sell your home. With Meridian’s port and refinance flexibilities, however, this restriction will not dissuade many borrowers.

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Many argue against variable-rate mortgages given that rates “can’t drop much more.” But while it’s true that rates are near the bottom, there’s still a question of “where’s the bottom?”

The Bank of Canada’s floor for the overnight rate—the rate that drives prime rate—was previously established at 0.25%. It sat at that all-time low from April 2009 to June 2010.

At the time, Governor Mark Carney said:

“…We thought long and hard about where the effective lower bound was in Canada. Our judgment was—and it’s been validated, I think—that we could bring rates down to 25 basis points…and that markets would continue to function well.”

“Because there are transaction costs associated with operating [shorter-term money] markets…if the net yield is close enough to zero, then those markets will cease to function.”

In its April 2009 Monetary Policy Report the Bank added:

“In principle, the Bank could lower the policy rate to zero. However, that would eliminate the incentive for lenders and borrowers to transact in markets, especially in the repo market. Therefore, to preserve the effective functioning of markets in a low interest rate environment, the Bank is setting an effective lower bound (ELB) of 25 basis points for the overnight rate…”

Much has transpired since then, however. Louise Egan, a spokesperson for the Bank of Canada, says that since 2009 “we’ve seen in some other countries that it’s possible for nominal interest rates to be negative due to the costs of holding currency, and so the thinking has advanced among central banks on the subject.”

In today’s world, if inflation risked falling below the Bank of Canada’s 1-3% target range, a 0% overnight rate wouldn’t be off the table completely, just unlikely. In fact, even negative rates are possible, as we’ve seen in many other countries. But according to Desjardins, “outside of an unlikely scenario where the Fed adopted such type of policy, there is little chance that the BoC would go this far.” Moreover, the Bank would likely use other monetary policy levers before it took extreme measures like cutting the overnight rate to zero or below.

“You know, for us, forward guidance is usually the next sort of place [we’d consider]…,” said Governor Stephen Poloz last month. “…What you’re doing in forward guidance is…you’re trying to influence not today’s interest rate, but how interest rates are perceived through the yield curve, so that you’re affecting the profile of expectations for interest rates…That leads to…more financial stimulus than you otherwise would have with a normally shaped yield curve.”

“The Bank, of course, did use some forward guidance in the past,” Poloz added. “We said that when we would normally use it would be in unusual times or at the zero lower bound…”

That is consistent with its prior usage, notes Bank of America rate strategist Ruslan Bikbov. “We saw back in 2009…the next step after the quarter-of-a-basispoint (overnight rate) was forward guidance,” he says. “They haven’t actually discussed the possibility of negative rates, or even zero.”

The Bank of Canada, as noted in this paper, can “reduce long-term interest rates by issuing forward guidance…” Doing so “lowers market expectations of the future path of the policy rate.” In turn, the 5-year government yield would likely drop, as would longer-term fixed mortgage rates.

If forward guidance doesn’t work, the BoC could try its hand at quantitative easing (QE). That’s where the Bank buys government securities in order to keep prices up and rates down. The fear, however, is that QE could remove bonds from trading, negatively impacting liquidity in Canada’s small-ish government bond market.

If QE did come to pass, it could potentially mark the long-term bottom in rates. That’s partly because its stimulative effect would likely result in higher inflation expectations, alleviating the need to ease policy further.

Given the BoC’s comfort with a 25-bps key lending rate, the 1 in 4 mortgagors with variable rates may see prime rate drop no more than another 10-25 basis points from here, depending on banks’ generosity following another 25-bps BoC reduction. And another cut is still very much on the table with Canada heading towards a “low-magnitude recession,” and with overnight index swap traders betting on a rate cut by January.

The wildcard is the Federal Reserve. It could hike rates later this year—some speculate as early as September. Of course, Canada’s rate market could always keep diverging from the U.S., but given the long-term correlation of U.S. and Canadian rates, a Fed hike could easily keep Canadian rates level, if not boost them somewhat.

“If the Fed moves in September, you will probably see higher rates in Canada, including five-year bonds,” said Bikbov. “By December, we may see another cut from the Bank of Canada and potentially another hike from the Fed. I think the net-net effect will probably be a five-year rate (in Canada) that’s a little bit lower.”

At the very least, we have lots more rate volatility and uncertainty to look forward to. So if you’re a mortgagor watching all of this, hold on for the ride. Rates in the second half of 2015 could be one surprise after another.

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Some odds and ends from the week’s mortgage rate action…

The Misleading Core…

One can be forgiven for wondering why the BoC cut the overnight rate ¼ point on Wednesday when its official “core” inflation measure is above target.

As it turns out, core inflation (which has stubbornly risen to 2.3%) doesn’t tell the whole story. Governor Stephen Poloz believes the “underlying trend” is actually much lower at 1.50% to 1.70%. “The Bank of Canada tries to strip out transitory factors in determining the underlying trend,” explains DLC Chief Economist Dr. Sherry Cooper. The biggest transitory factor at the moment is the boost in import (input) prices caused by our plunging loonie.

“But this is not inflation,” she explains. “Inflation isn’t a one-shot increase in prices. It’s an ongoing spiral up in prices.”

Don’t get too hung up on the BoC’s 2% inflation guideline either, Dr. Cooper cautions. “Inflation targets aren’t meant to be binding without judgment,” especially with the “R word” looming.

The DoF may tap the brakes again

Seven years of mortgage rules can’t keep the major markets down. Debt levels and home prices continue deviating from incomes, despite the Department of Finance’s efforts.

With this week’s cut and record real estate numbers, things have gotten interesting. When you get heads of real estate companies joining the BoC’s chorus about housing vulnerability, you can rest assured that policy-makers are on high alert.

The last thing rule-makers want is a housing calamity. The second-last thing they want is to be seen as not being proactive before a housing calamity. For that reason, the odds that tighter mortgage guidelines are on the way have just leaped.

TD’s Gambit

TD was ready for the rate cut. It announced a 10 bps reduction in its prime rate just 12 minutes after the BoC’s statement. It seemingly wanted to set the trend and perhaps get out in front of consumer backlash from banks withholding part of the quarter-point cut.

TD’s move would have been well played, had the other Big 5 matched its rate. But they didn’t. RBC, the biggest kahuna in Canadian mortgages, decided to trump TD’s less generous rate and drop prime by an extra 5 bps to 2.70%. “They just wanted to make TD look bad,” said one capital markets source.

Not to lose face (and business) over a 5-bps-rate difference, TD quickly relented and matched 2.70%. Being first to announce prime rate entails a lot more reputational risk than it used to.

The Banks Stole My 10 Beeps

About 1 in 4 mortgagors has a variable rate. And they choose variables because they expect to receive every basis point of BoC rate cuts.

But big banks haven’t been in a giving mood lately. They’ve passed along only 60% of the benefit of the last two rate cuts. This latest “spread pocketing” has driven the prime – overnight difference up to 220 bps, 45 bps higher than in 2008.

Here’s a look at how the prime – overnight spread has been creeping up.

But why?

RBC cited this as its reasoning for passing along only 60% of the rate cut:

“Our decision is consistent with the rate adjustment that we made in January when the Bank of Canada previously lowered their rate. It is meant to balance the interests of our clients who are always top of mind, with the costs that we incur to provide our products and services.”

What bank critics don’t acknowledge is that

  • Every single year, shareholders demand to be fed with a steady diet of earnings and dividend growth.
  • Banks have a minimum target spread they need to earn between what they lend and borrow at.
  • The Bank of Canada’s rate cut instantly shrinks lender spreads on variables—partly because banks fund much of their variable-rate book from deposits. They can’t really lower those deposit rates since they’re already near/at zero. Banks feel they have little choice (if they want to maintain spreads) but to pass along only a fraction of the rate cuts.
  • Adding fuel to the fire is that variable-rate MBS spreads have been steadily inflating this year—i.e., it’s getting relatively more expensive to fund variable rate mortgages using mortgage-backed securities.
  • On top of that, funding costs have risen on other parts of their mortgage book, thanks in part to widening swap spreads.

The interesting part is that this time around, you can barely hear any consumer outcry in the media—compared to when the banks last pocketed some spread in January. And that’s just the way banks like it.

Coming Up Next for Rates

The markets are pricing in a fair probability of another BoC cut on September 9, 2015. By then, the Bank of Canada will have data confirming if Canada is in a technical recession, more visibility on oil prices, as well as two more employment and inflation reports.

If the BoC lowers another quarter point, there’s a good chance that banks will again hold back some of the cut.

As for fixed rates, 5-year yields have been in a clear downtrend and the 0.55% record low is just 15 bps away. If yields makes a new low, fixed rates will do the same. But the same margin concerns that kept banks from lowering prime ¼ point will also keep the average 5-year fixed – bond yield spread closer to 165 bps than the 135 bps of old. In other words, we may not see overly generous fixed-rate discounting for some time.

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HurricaneThere’s been a perfect storm brewing in the mortgage rate market, one that’s bringing volatility and uncertainty. And it all came to a head today.

Here are some of the factors impacting mortgage rates at this moment:

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Greek Default & Cascading Yields

The home of the gyro became the first developed nation ever to default on IMF debt. S&P now pegs the odds of Greece departing the EU at 50%.

Virtually no one expects the Grecian debacle to trigger global financial catastrophe, but investors have taken no chances. They’ve piled into AAA bonds for safety, which in turn has pounded Canadian yields to a two-month low. In just the last two days alone, our five-year yield has nosedived 22 basis points.

Despite the bond/fixed-rate correlation, don’t count on an immediate reduction in mortgage rates. Lenders usually wait a bit for the volatility to end before repricing.

More GDP Disappointment

There’s actually a chance Canada could be in recession and we just don’t know it yet. April’s GDP came in negative today, which makes it four months in a row of negative growth. We haven’t seen that since the financial crisis. If the economy shrank in May/June, that, folks, is a recession.

“In Canada we won’t know (about the recovery) until May,” says BoC governor Stephen Poloz. With the U.S. economy improving, negative growth in Q2 is still viewed as unlikely, for what that’s worth.

Whipsawed BoC Expectations

Last week, traders were pricing in rate hikes by mid next year. After today’s news, there’s now a 50%+ chance of a rate cut in the next few BoC meetings.

That’s got CIBC star economist Ben Tal reversing his engines. He now says, “…We change our call to a 25-basis-point rate cut by the Bank on July 15th.”

In fact, a slew of economists are now jumping on the monetary easing train. See this Financial Post Article.

New Mortgage Regs

Finance officials have intervened in the mortgage market again.

The Finance Department has been promising to ban the use of government-backed insured mortgages as collateral in non-CMHC-sponsored securitization. Well, it essentially started imposing that ban today, June 30.

The DoF is also prohibiting lenders from using portfolio (bulk) insurance unless they pool the insured mortgage in a CMHC-governed security. The problem is, with all the restrictions now placed on mortgage-backed securities (MBS), lenders can’t be sure they’ll be able to fund their insured mortgages through CMHC programs.

One of the various repercussions is that lenders can no longer directly fund insured mortgages with asset-backed commercial paper (ABCP). That’ll have an immediate impact on avid users of ABCP, the likes of First National, MCAP and Investors Group. Big banks who fund mortgages with deposits, covered bonds, bankers’ acceptances, etc., are relatively less impacted by this measure.

Literally every single lender and capital markets pro I’ve talked to has the same opinion: the government overreached here.

One capital markets exec we spoke with called the $10 to $12 billion of mortgages in ABCP a “rounding error” on Canada’s $1.3-trillion mortgage market. It’s almost a joke that Ottawa would target it. Policy-makers could have preserved this funding method to improve competition…but they dropped the ball.

It seems the DoF was more interested in teaching banks a lesson for using bulk insurance to improve their capital position a few years ago. As a result, it has restricted this insurance (which smaller lenders rely on for securitization purposes, and that keeps all lenders more competitive).

“They’ve thrown the baby out with bathwater,” said one lender executive about the Finance Department. “The government already assumes the risk with insured mortgages. How a lender funds their mortgages doesn’t add more risk.” A main problem with bulk insurance previously was that it was underpriced, encouraging its overuse, he says.

Another new rule is that lenders must now securitize bulk insured mortgages within six months. Otherwise the insurance and premium paid are lost. This seemingly innocuous rule has just opened up a bag of headaches for smaller lenders on refinances, variable-to-fixed rate conversions and renewals.

For example:

  • On renewals: If a client renews and wants a one-year term, a small lender who bulk insures may have a problem. Reason being, it’s hard to securitize one-year terms. Monolines will have to sell to a bank who buys uninsured short-term mortgages, and that’s more expensive—meaning higher rates for that lender’s customers.
  • On refinances: The same principle applies to mid-term refinances where (for instance) the customer breaks halfway through a five-year term and leaves the lender with a 2.5-year asset that’s difficult to pool for securitization.
  • On conversions: The impact on short-term funding could force many smaller lenders to restrict conversions from variable-rate mortgages so that the borrower must convert into a five-year fixed instead of a shorter term.

For more on the regulatory amendments affecting lenders and funders, read this and this.

These measures will reduce mortgage discounts among bank challengers, especially on conventional mortgages. That, in turn, will likely cause banks themselves to price less aggressively since banks are continually looking to maximize margin and not lead on rate.

If you have a comment on these new regs, let the DoF know at finlegis@fin.gc.ca (reference “Canada Gazette, Part I, June 6, 2015, and address it to Wayne Foster, Director, Capital Markets Division, Department of Finance, 90 Elgin Street, 13th Floor, Ottawa, Ontario K1A 0G5).

CMB Allocations Dry Up

The Canada Mortgage Bond (CMB) is generally the cheapest source of mortgage funding. Problem is, there’s not enough of it to go around. The Finance Department limits issuance to $40 billion a year and there’s a long line of lenders who want it—so long that the allocation has plunged to a record low of roughly $150 million per lender per quarter for five-year fixed funding. Not long ago, the allocation was well over double that. (Incidentally, according to people who watch this market, credit unions are using up an increasing amount of CMB bandwidth.)

Spread Inflation

MBS and CMB spreads have been growing, which boosts lenders’ funding costs. The last CMB, for example, was launched with a spread 8 bps wider than in March, “indicative of the overall widening in credit spreads this year,” said First National’s Jason Ellis in a June 12 blog.  (By the way, if the acronym CMB means anything to you and you don’t subscribe to his blog already, you need to.)

As Ellis also pointed out, the feds are apparently closing “a tax loophole related to total return swaps linked to securities like NHA MBS.” This makes it less appealing for some institutional investors to hold MBS. According to one capital markets source, “It’s been uncertain as to whether [pension fund MBS] trades are going to be unwound quickly, slowly or grandfathered. All the budget said is, effective October 2015 this is going to end, without any details.”

This pending development is making MBS participants nervous, which means lenders must now pay a premium to securitize with MBS. That’s on top of CMHC’s new guarantee fees earlier this year.

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Mortgage shoppers watching yields dive are hoping borrowing costs will follow suit. But rates, if they do fall, will drop less than expected thanks to government intervention and resulting funding cost pressures behind the scenes.

Earlier today we saw some smaller lenders actually raise rates 5-10 basis points. You don’t usually see that with bond yields down framatically. Some in the know believe that a new 10+ bps premium could now be built into rates for years to come, regardless of what the Bank of Canada and bond market do, and regardless of how slow the housing market gets.

More From the Rate Front…

Borrowers got what they were asking for. It just wasn’t as big as they were asking for.

The major banks cut their prime rates by just 15 basis points today, to 2.85%. It’s the first time ever that Canada’s official bank prime will have changed by less than ¼% (at least back to 1935 when the Bank of Canada started publishing this data).

RBC showed leadership by being first out of the gate with its prime rate announcement. Then came BMO 50 minutes later, follow by the rest of the pack.

This all comes after TD Canada Trust worried borrowers last week, telling them it wouldn’t cut prime rate at that time.


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Rate Nuggets

Some rate news of note:

  • RBC led the banks this morning by trimming its posted 5-year fixed rate. It dropped 10 basis points to 4.84%, the first 5-year posted rate cut from any major bank since spring 2014. If other banks follow as expected, the benchmark qualifying rate will drop, making it slightly easier to get approved for variable and 1- to 4-year fixed mortgages.
  • Those looking to Canada’s top bank for leadership on prime rate will have to keep waiting. RBC cut its 3-, 7- and 10-year fixed rates as well, but left its prime rate at 3.00%.


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A Historic Day for Yields

This has been one spectacular swan dive in the 5-year Canadian bond yield. We ended Thursday at 1.01%, an all-time low and just a “beep” above the psychological threshold of one percent.

If you’ve been watching this waterfall in yields over the past two months, you may well be wondering, “If bonds lead fixed mortgage rates, when will we finally see some rate love from lenders?”

In the past, when long-term yields have moved 15-20 basis points, lenders have adjusted fixed rates accordingly. But today is a different world. The banks, which control over three-quarters of the mortgage market, will be “ruthless” at protecting earnings, analyst Peter Routledge told the Financial Post.


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Canada Should Trail U.S. Rates

Canadian-US-mortgage-ratesThis week, the U.S. central bank put the world on notice that rate hikes are coming, possibly as early as spring.

While we shouldn’t hold our breath on that, it does raise one important question: How will the Bank of Canada respond if the U.S. does boost interest rates?

The answer is far from certain, but one thing can be said with confidence: the BoC will not respond in knee-jerk fashion.

Here’s why, and what it means for mortgage holders:


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A Breakdown of Credit Union Rates

Those in the lending world increasingly acknowledge credit unions as a competitive threat. Mortgage rates are a large reason why. 

“The…big differentiator…for many [credit unions], but not all, is very competitive and transparent pricing on mortgages,” banking analyst David McVay tells The Canadian Press (CP). That compares to some banks’ posted rates, which are as high as 4.99% on five-year terms. 

But the phrase “competitive and transparent” needs defining. Any praise we heap on credit unions should be put in perspective because they are far from created equal.


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