A Side Effect of Rate Warnings

Binoculars and Mortgage RatesThe 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?

Normal-AheadLong-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.

Projecting-the-neutral-policy-rateEven 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

  1. The Doctor tends to ask questions before prescribing a solution to your mood swings. Maybe instead of taking anti depressant pills, you should stop watching the news just before going to bed, or consider divorcing your in laws
    A mortgage broker who asks his clients A LOT of questions and then a few more, can assist in recommendations that are designed to solve problems rather than creating new ones

  2. Very smart article, we all need to think about the fact there may be a “new normal”, sometimes simply pointing at the past is not the right approach. As mortgage brokers if we lay out these kind of salient facts to our clients and ask those key questions about the client’s future plans and most importantly: do NOT pretend we know the future in a perfect way, we serve the client best. Often today when talking to clients I tell them: “not knowing the future for a certainty, I tend to default to the lowest possible rate” We do need to ask all the right questions to analyse their goals but just telling everyone “rates are sure to go up so lock in long term” is not a universal response.

  3. Low rates ARE the new normal. One day people will realize this.
    And by low, I mean low against histroical averages.
    Japan rates have been tryin gto return to “normal” for what, 10… 20… or is it 30 years now? OR could it just be that their rock bottom rates ARE the new normal?

  4. Great article Rob. I think one of the other contributing factors to pricing that may be worth considering in future topics you cover is the Government’s desire to no longer be the back stop insurer for mortgage defaults in Canada. We are seeing this via policy, but I wonder if it finds its way into pricing via risk based as we have seen in the US with more private default insurers.

  5. I am not a mortgage professional. I am just a guy with a mortgage who would like to thank Rob for the effort he puts into this site and for the posters (mortgage professionals and non)for their commentary.
    The quality of the information on this site is incredible. Thanks….and by the way this site has helped me and continues to guide me as I work with through the last half of my prime -0.7 five year variable.

  6. I love this post and I think it speaks to those who took on mortgages or got pre-approvals two or three years ago and now that their condo unit is almost built, can’t come up with the down payment for it and risk being sued by the developer (there was a great article about this run in a major paper this week.) One must really take ALL possible scenarios into consideration when getting a mortgage and get the one that’s best for them today AND tomorrow, even if that means not getting one. Fabulous post, Rob, and no, I don’t think mortgage rates will jump too much even when the overnight rate gets bumped up a notch or two. It will be years before we see anything that will be considered “high rates” and yes, Julie Dickson may be trying to use unecessary fear tactics.

  7. Great article Rob and great commentary from the commentators. I particularly like Ron Butler’s comments regarding the dangers of referring to the past in order to predict the future, as well as his recommendations to clients to default to the lowest possible rate. This is a strategy that many of us in the mortgage brokerage industry encourage our clients to adopt. We haven’t gotten it wrong yet.
    Please forgive me for referring to the past, but having been in this business for almost 4 decades, my opinion is that there is no “normal”. The best we can do to optimally serve our clients is arm them with pertinent facts and help them make a decision.
    Lou Perrotta, CPMB

  8. As much as I would like to think that history repeat itself, I agree with Lou. For me, the norm is what we are dealing with now. Times are changing, economy wise and global events plays a big factor as well.

  9. I too think low rates are the new norm. There was a day when I believed “them” but I think that manipulating the media is their only threat to the real market and those conditions.

  10. With 5 year fixed rate mortgage jumping by around 17%-20% overnight just a couple of months ago, it is interesting to read about people thinking low is going to stay the normal. This massive jump which did happen overnight went unrecognised by 99% of consumers and would only have been felt by current home buyers who saw the jump while in the process of recently buying a house. I can assure you that the “experts” knew a rate hike was coming, but none of the “experts” knew it would happen to the extreme that it did. My friends, remember when the first cycle of Monetary Stimulus was actioned in the US (QE). The big experiment to pump money into the economy took 4 years for the tsunami effect to hit. How many more QE’s has there been since? Just wait, it will hit rates shortly.

  11. Actually Stephen, it already did hit, the expectation of the tapering of QE is exactly why the rate increases occurred that you referred to in your first sentence. There will be further increases in fixed rates although the timing of them is clouded by uncertainty about when the tapering will actually start.
    Our comments are really directed at Prime Rate based mortgage rates and those increases could possibly take 18 to 24 months to happen.

  12. While important to pay attention to central bankers, the market demonstrates it’s effect on fixed rates when alternatives to lending money to government become more appealing. When employment improves, markets will change again and fixed rates will rise just like earlier this year. There is simply too much cash in the market and investor choices will not be predictable

  13. This view may be dangerously wrong. The Fed and all the other central banks actually _follow_ the market. Their statements and forecasts are akin to a TV weatherman’s.
    Central bank “policy” consists of setting a target rate at a nice round number slightly below the 3 month bankers’ acceptance rate, and talking #%@& like the Wizard of Oz.

  14. Everyone knows that rate hikes are coming. The question is when and how high. When the Fed moves on rates I wouldn’t be surprised to see 5 year fixed mortgages around 5.00%. That is still low historically speaking. People who think 5 year mortgages will rocket to 6.00-7.00% and stay there are overestimating a very mature U.S. economy.

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