The Fed’s Constraint on Canadian Rates

Uncle Sam Desperate for CashOne could wax on about how grim the U.S. economy is, but Mark Carney put it succinctly:

“The (U.S.) housing market remains a mess, the consumer is weak, and government actions can be expected to reduce growth…The U.S. economy is close to stall speed…”

That sort of thing puts Canada in a quandary. When the American economy is in the toilet, the Canadian economy is usually on the rim, ready to fall in.

The Fed itself admits that the U.S. is facing “significant downside risks” and 3 out of 4 Canadian exports go to the States.

The mortgage-relevance here pertains to how America’s woes affect Canadian interest rates. To answer that, let’s first have a look at the historical policy rate differences between the two countries…


(Click chart to enlarge)

This chart by TD Securities shows how the Bank of Canada has deviated from the Fed in the past. Since 2000, when the BoC adopted fixed announcement dates, Canada’s key lending rate has never exceeded 225 basis points above the Fed funds target rate.

At the moment, no reputable economist foresees that level being eclipsed anytime soon. The reason: If the BoC got too aggressive it would drive up the loonie and punish economic growth.

On the other hand, Carney was clear on Tuesday that, “We do not outsource our monetary policy to the U.S. Federal Reserve.” That means the BoC will raise or cut Canadian rates depending on domestic inflation prospects, not what’s happening south of the border.

So where do rates go from here?

At this point, the Fed seems almost impotent in its ability to spur the U.S. economy. Its latest adrenaline shot (a $400 billion bond swap) is likely too small and too drawn out to ignite a recovery. U.S. fiscal restructuring and global economic events (including the Eurozone debacle) will ultimately determine the fate of mortgage rates.

Just for argument sake though, suppose the Fed maintains the status quo on rates until third quarter 2013 (as it forecast). In that case, Canada will be hard pressed to raise rates extensively.

For what it’s worth, here’s what the crystal ball gazers (major economists) are forecasting now:

  • 2012 will see 75 bps of hikes (as per the Big 6 banks’ current published forecasts)
  • The next rate increase will occur in Q3 2012 (according to the latest Reuters dealer poll)
  • 2013 will see rates rise an additional 75 bps (based on the limited number of economic forecasts stretching out that far)

Rate-DirectionDo not bet the barn that these forecasts won’t change. In fact, don’t even bet the rooster wind vane that sits on top of the barn.

That said, if economists are remotely accurate this time, the above forecasts represent 150 bps of tightening in the next two years.

This implies a 4.50% prime rate by year-end 2013. (The 10-year average of prime is 4.27%.)

Based on the above hypothetical and a properly qualified borrower, the mortgage value zone remains in the 3- and 4-year market. Both of these terms are still available at 2.99% or less and they’ve performed quite well in a variety of our rate simulations.

Conversely, if you’re a little more bearish on the economy and want to speculate on fewer rate hikes through 2013, today’s 2-year fixed at 2.49% is tough to beat.

Even a surprise BoC rate cut (which OIS traders predict in defiance of economists) leaves the 2-year in okay standing. A prime – 0.45% variable may have the edge if rates drop, but the 2-year fixed guards against inflation risk and rate hike potential in 2013. Moreover, you can potentially early renew your 2-year fixed (or lock in a fixed or variable rate elsewhere) up to six months prior to maturity.

Chart Source: TD Securities

Rob McLister, CMT

  1. It’s amazing how quickly a no-brainer decision can seem like a mistake in the mortgage world. I signed up for a 5 year variable mortgage at prime-0.9 (2.1%) a couple months ago when it seemed like that was the obvious correct choice. At least I’ve somewhat helped my situation by sizing my payments as if I have a 3.8% fixed.

  2. OTTAWA – Finance Minister Jim Flaherty is warning of a second financial meltdown on the scale of 2008 if action is not taken, saying he is frustrated by the lack of response from policy-makers.

  3. Hi Mark: That’s true and it looks like we’re on same wavelength. A story update was posted to this effect 15 mins ago.
    Hi Jeff: You’ve got a bargain rate and it’s something you can probably ride out for a while depending on your financial situation. They don’t make them like P-0.90% anymore…

  4. Hi Rob,
    Amazing insight! I have been following your site, and it’s the first place I go to after the Fed makes an announcement on either side of the 49th Parallel. I have a 5 year Fixed Variable at 2.4% for the last two years and I have been pumping in as much money as I can to bring down my principal. I hope the prime rate goes down again….Rob, have you ever come across Gerald Celente of Trends Research in the U.S. His outlook, based on consumer trends, forecasts a very gloomy outlook for the U.S. economy for the near future. Have you thought about writing an article on some of these individuals, like Celente or Peter Schiff, and what their predictions are for the US economy and what it means for us.

  5. I agree with Mark. A one time injection of money by the government into the economy is a recession. A consistent, and prolonged injection of money into the economy is due to a depression. What do you think? I say stick with the variable for another year at least.

  6. Why gamble on a 2.60% variable when there are 3 year fixed rates of 2.79%? You might save a few bucks in the first year but mortgages last longer than a year.
    I love these people who believe they can lock in at the right time. They are delusional and need treatment. Most get bent over twice. First by botching the timing and then by getting a pisspoor conversion rate from the bank.

  7. “The world is recovering from a once-in-70-years financial crisis and is suffering from debts not seen in decades. This is not a traditional, cyclical recession. It’s a debt crisis.”
    about variable on Prime minus .9 and fixed rate … I’ll still choose Variable … for now

  8. “We do not outsource our monetary policy to the U.S. Federal Reserve.”
    I don’t know about this? Can you put up a historical interest chart? I think you will see rates going over a cliff following that of the US when Carney could have keep them where they were. The results of which he is talking about but he is looking in the rear view mirror. IMO.

  9. Where do you get prime minus .9 today? I can only find prime minus .4 from my bank. In this case 2.49% fixed is looking pretty good right now.

  10. I was able to get a prime minus 0.9 two months ago. The deep discounted rate from the same lender is now prime minus 0.5.

  11. Hello Robert,
    About the same time 1yr ago your advice “1yr fixed is preferrable if you could get it close to or less than variable” made lot of sense to me. I took it and am very happy I did. This time you don’t mention this option, why? I’m trying to choose between 1yr @2.5 or 4yrs @2.99 as my bank’s 2yr @2.8 and VRM @-.4 aren’t that good (I don’t want to transfer at this moment). Thanks.

  12. Very kind Steve. Thank you.
    Celente and Schiff (“Dr. Doom”) have had some big calls. The challenge is, like most prominent forecasters, you never know when they’ll be right and when they won’t. They bring a lot of key economic trends to the forefront and there’s certainly value in that. But I’d be very careful about trading on their forecasts because timing is everything. It’s a lot easier to get macro trends right than it is to get them right at the right time.
    Whatever the case, mortgagors who believe Celente & Schiff’s depression predictions will probably want to stick to variable or shorter mortgage terms. :)

  13. Hi Pavel,
    Thanks for writing in. Oddly, there’s a shortage of bargain 1-year rates at the moment (unless you live near Calgary where First Calgary CU has a 2.39% special).
    That leaves more value in 2- to 4-year terms or in variable rates (if you can find prime – 0.50% or better).
    Wish I could help in your case but it’s tough to make a specific recommendation given the limited fact pattern in your post. That said, the rates you quoted are certainly competitive.
    All the best…

  14. This is a great site. i am loving the insight! I’m having the hardest time right now choosing between p -.65 for five years variable versus 2.99 for four years fixed. Also getting about $3,000 from the bank on the fixed to help pay off the penalty for early cancellation. Any thoughts?

  15. If you can get 2.99% fixed with no penalty I’d take the 4 year fixed. If prime goes up 1% in 2013 you are ahead of the game.

  16. Actually, in the scenario you describe, you would not be ahead.
    Such misinformation is why everyone should discuss their individual needs with a reputable mortgage professional that has the tools and experience to properly advise.

  17. I’m trying to find a bank or mortgage broker, who’d help to pay off my penalty to break off my current mortgage. So far no one is agreeing on doing this…

  18. Let me know how that works out for you. I am looking for a bank or Mortgage broker who will make my payments for me also. But alas no one has agreed to do this…lol.

  19. Lenders and brokers don’t pay penalties and if they do the rate is higher to compensate. No free lunch honey.

  20. This mess in Europe is going to keep the markets so rattled that the rates should remain unchanged until 2013. They can pump all the money they want into Greece, but there are minimal systemic changes occurring. No new jobs are being created in all this money being spread around. Greece has become the “sick old man” of Europe, and everyone is afraid to pull the plug. Plus, let us not forget that America still has to pass a proper budget. October should be an interesting month to say the least. I think we have been isolated in Canada, and we have better social programs than America, and a much tighter noose around the necks of our CEOs and banks.
    In short, I think I’ll win in the end with the variable. If all of us follow the variable path, the banks will have to make better offers in regards to their fixed rates.

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