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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