1-Year Terms Looking Better With Latest Fed Forecast

OLYMPUS DIGITAL CAMERAOn Wednesday, the Federal Reserve dished out good news to mortgagors holding short-terms or variable rates.

The U.S. central bank threw a curveball at financial markets by projecting “extraordinarily low levels” for American interest rates through “at least” 2014. That’s a full year and a half later than its prior forecast.

With an 83% correlation* between Canadian and U.S. policy rates, this news will certainly impact Canada’s mortgage market.

FedBesides its headline-making forecasts, the Fed also followed in the Bank of Canada’s footsteps by announcing a new 2% inflation target.  That, it says, should “moderate long-term interest rates” (which is again positive for Canadian mortgage rates long-term).

Mortgage Impact

With North American central banks now expecting low rates well into 2013-2014, consumers will have greater confidence in shorter-term mortgages. The 1-year fixed in particular may look increasingly tempting.

One-year terms:

  • Are at least 1/4% below most variable-rate mortgages
  • Offer 1/2%+ interest savings for 12 months compared to most longer terms
  • Let you lock into a new mortgage rate in 6-9 months (depending on the lender and rate hold you select)
  • Give variable-rate adherents the potential of securing a better variable discount in one year. (Variable mortgages are presently overpriced, that is, unless you foresee BoC rate cuts.)
  • Are sometimes convertible without penalty into a fixed or variable-rate mortgage (Among national lenders, FirstLine has the most flexible and cost-effective 1-year convertible at the moment. You can find some brokers offering them in the mid-to-upper 2% range)

The Fed’s Disclaimer

interest-rate-newsUsing the Fed as a guide for Canadian interest rate policy is not without risk. For one thing, it’s quite possible that Canada’s rates rise before those in the U.S. Up until yesterday, most economists have been projecting that Canada’s first hike will occur roughly six months before the U.S. (For what that’s worth.)

More importantly, the Fed is not committing to low rates through 2014. It’s merely projecting them. It calls its forecast a “best guess” that is subject to revision.

Credit Suisse economist Dana Saporta reminds everyone that not even the Fed can accurately predict rates 2-3 years out: “Given that no one knows what will happen (in a few years)…the (Fed) may eventually regret this.”

BoC chief Mark Carney said that Canada will not be issuing predictions of its own. “There’s a sense of false precision that can come from a single (forecast),” he said last week.

Despite that, Fed chair Ben Bernanke stated Wednesday: “Unless there is a substantial strengthening of the economy in the near term, it’s a pretty good guess we will be keeping rates low for some time.”

Sidebar: According to Action Economics (AE), here is the breakdown of votes that occurred during yesterday’s Federal Reserve meeting:

  • 3 Fed policymakers favour the first rate tightening occurring in 2012
  • 3 favour 2013
  • 5 are for 2014
  • 4 for 2015
  • 2 for 2016

“So that puts the bell curve apex in 2014,” said AE market strategist Michael Wallace.

As for the projected level of the Fed’s key interest rate:

  • 9 Fed policymakers see a target below 1% at the end of 2014
  • 3 see 1-2%
  • 5 see 2-3%.

As usual, core inflation, or the threat of it, should ultimately determine if rate hikes precede central bank forecasts.

* This correlation coefficient was measured using monthly overnight rate targets for Canada and the U.S. from January 1993 through January 2012.

Rob McLister, CMT

  1. It appears the Fed had little choice. The struggling U.S. housing market is currently a big drag on their economy and appears to be several years from full recovery.
    Raising interest rates would only make a very bad situation worse.
    Projecting low and stable lending rates for such an unprecedented length of time truly remarkable.
    It’s also interesting to see the U.S. finally agreeing to the concept of inflation targeting, a monetary strategy that Canada has followed successfully for many years.

  2. I’m a bit confused about the quotes provided in this article. Maybe someone can provide a bit more clarity.
    How can the majority consensus be that rate tightening will most likely occur around 2014, but then say that the consensus on the fed key lending rate will most likely be below 1% by 2014.. isn’t that contradictory?

  3. Right now the rate in the U.S. is 0.25%, so they are projecting an increase but not more than 0.75% by 2014. Maybe you are thinking of the higher Bank of Canada rate?

  4. Variable mortgages are currently, very overpriced. It makes no sense to me why any fixed should ever be priced lower than Variable and especially when F.I.’s have to carry the costs on all their fixed mortgage rate hold commitments. Also Variable mortgage takers are now better qualified than fixed since they qualify at higher, posted 5 year rates. If these 1 year terms continue to be priced this low, Variable rates will have to drop soon.

  5. Lenders must hate this kind of announcement. It effectively takes the “variable” out of variable rates!
    Two years ago, I found it very strange that so many banks forecasted pretty steep — by today’s standards — prime rate increases (into the 3% range). I always felt that there would be massive downward pressure keeping rates low. A move to 3% would send Vancouver over the deep end. And how can inflation get out of control with a black hole of debt there to vacuum up excess currency?!
    Anyway, banks “caught on” — surprisingly late IMO — that rates weren’t going anywhere fast, and that’s why the usual discount on variable rates has disappeared.
    Hypothetically, it would be dumb to take a 5-year fixed at a premium when a 5-year “variable” is nearly a sure bet for 2 of those years (minimum). All else fails… refinance after the free ride.
    It was inevitable for fixed rates to become more competitive in an “interest rate freeze” environment.

  6. Apologies: please read “overnight rate” in place of “prime rate”. I do realize that prime is AT 3%, but 5% prime is simply inconceivable right now.

  7. 5% Prime is just normal, I would say, nothing will sink if prime gets to 5%.
    people will just have to stop paying 80+$ per month for iPhone bill and will compensate for it

  8. Those should never borrow at the first place if you ask me.
    Rates should stay low, but mortgage lending conditions should tighten to avoid more people with little income to borrow huge amounts of money they can’t afford to pay off.
    At the other end, it’s good to have more people with huge debt and at a brink of default, so the BoC and govt can’t risk to increase the rates too much.
    The worse is that they (govt) increase prices on everything else in our lives, so while you watch your mortgage rate, you will wake up once day realizing everything else is 25% more expensive already.
    Smart people will use the situation for their benefit.

  9. Whether people should borrow in the first place is not the point.
    If prime goes to 5% affordability will worsen. Unless demand offsets the resulting supply, and I don’t think it will, then 2% higher rates would be a net negative for home prices.

  10. Home prices will inevitably go higher (except where they already are very over inflated).
    Increasing someone’s property municipal evaluation with 40% results in higher selling price.
    House prices will still outperform Inflation rate I think, regardless of the Overnight Rate value.

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