“The longer it (low interest rates) goes on, the more people can start to think this is normal and it’s not normal; it’s very, very far from normal.”— Julie Dickson, OSFI Superintendent, Sept. 23, 2013 via MortgageBrokerNews.ca
When people hear an authority—like the head of Canada’s banking regulator—make these statements, it compels many to lock in to a long-term rate.
At the very least, it gets a whole lot of people wondering, “What are normal interest rates?”
If you ask many economists, “normal” is an overnight rate that’s 2.00 percentage points higher than today.
If you ask a lender, “normal” may be the 20-year average of 5-year posted rates (i.e., 157 bps higher than today) or the 20-year average of prime rate (which is 207 bps higher than today).
If you ask the Bank of Canada, its answer is: “We can expect that short-term interest rates, as is normal, will be above inflation.” Given that it tries to keep inflation near 2% long-term, a 2.50%-3.50% overnight rate seems plausible (we’re at 1.00% today).
Someone could reasonably look at all this and conclude that rates may rise up to 2.00 percentage points from here.
Does that put us “very, very far” from normal? You can decide for yourself. But an equally valid question is:
How can one compare today’s normal with the norm from 20 years ago?
Long-term economic growth has never been so low. Central bank inflation targeting has never been so diligent. Nor did we (20 years ago) have the modern Internet, widespread global outsourcing and free trade, energy independence and so many other anti-inflationary mechanisms.
As a result, one could argue that long-term inflation risk (the #1 threat to low mortgage rates) has permanently diminished vis–à–vis the 1970s, 80s and 90s. Unquestionably, there will be inflationary spikes at some point. But long-term, the fundamentals support rates that are lower than their long-term averages.
So, while it’s unquestionably good public policy to discourage complacency with low rates, the side effect is that it also encourages more people than necessary to lock into higher fixed rates.
If one assumes the following:
A well-qualified borrower
Deep discount rates (e.g. a Prime – 0.55% variable, a 2.89% 3-year fixed, etc.)
200 basis points of rate increases spread over 2+ years
That the first Bank of Canada rate increase will occur late next year or early 2015
…then it’s easy to make a mathematical case for a 2- to 3-year fixed instead of a 5-year fixed.
Even a 1-year fixed or variable could be appropriate for people with decent equity and a short amortization. (Ask a mortgage professional to analyze different term scenarios based on your personal circumstances).
In sum, we have to put the spectre of rate normalization into perspective. Some people completely discard the possibility of years of flat mortgage rates, or even eventual rate cuts. That’s a mistake.
When planning a mortgage strategy, all scenarios must be considered and weighted appropriately based on your risk tolerance. We must allow for things like the possibility that rates won’t increase in 2014. Scotiabank and Bank of America Merrill Lynch peg the first Bank of Canada hike in 2016. If you simulated that scenario, 5- to 10-year fixed mortgages would get roundly trounced by most short-term rate strategies.
Experts have been warning for years now that rates are well below “normal.” If it turns out that rates are not so far from normal as we thought, billions of needless dollars will be spent on long-term mortgages. If you’re a financially strong borrower, you might try to avoid being part of that statistic.
Rob McLister, CMT
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