The Chicken or The Egg
I’m sure you are asking yourself what the chicken or the egg has to do with the housing market or financing your property.
As a mortgage advisor, the question asked most often is, “should I go fixed or variable-rate with my mortgage?” It seems this question may be as old as the question of which came first, “the chicken or the egg?”
According to the April 14, 2022 edition of The Globe and Mail, “nearly 30 percent of outstanding mortgage credit has a variable-rate, up from just 18 percent before COVID-19. For eight consecutive months, variable-rate mortgages have accounted for more than half of new home loans, according to the latest Bank of Canada(BoC) data.”
It doesn’t hurt that variables have been priced at an average greater than 1.5 percent below the 5-year fixed rates.
However, with the June 22, 2022 announcement, more people may be questioning their faith in variables. As the real estate sector cools, the cost of owning or renting a home is climbing rapidly in the consumer price index (CPI), Statistics Canada’s go-to measure of inflation. The cost of shelter rose 7.4 percent in April, the largest annual gain since 1983. The increase can be pinned on several factors, from rising home energy costs to how Statscan measures the price changes facing homeowners. Making matters more challenging, the housing sector is likely to continue putting upward pressure on inflation – partly because mortgage rates are rising to multiyear highs and rents are soaring in urban centres.
The current inflation data could be enough to give over-leveraged borrowers the chills. Economists call for a CPI reading anywhere from 7.1% to 7.5%. That would make it the most menacing inflation print since 1983, when the prime rate was 11.5%.
As some second-guess the “variable-rate advantage,” we may hear more people asking questions like, “Is it too late to lock in?”
With fixed-variable spread intact (for now), most will probably conclude that floating rates still have too much lead to pass up.
You may have noticed something interesting about the fixed-variable spread. It’s roughly the same as the degree of rate tightening expected by the bond market.
“The market is smart and is usually good at setting 5-year [fixed] rates at a level that reflects expectations for future variable-rate movements,” BMO economist Robert Kavcic stated in an interview with Canadian Market Trends.
The 5-year fixed rates move with 5-year bond yields and Canadian yields are determined by all sorts of factors. The 5-year yield reflects the average expected BoC overnight rate over the next half-decade, plus a term premium. The term premium is the extra yield investors demand for the risk of locking up their money for five years.
It has been said that bond rates may indicate the BoC overnight rate. Where the bond rates are currently, we may continue to hold our current low BoC overnight rates.
One has to ask, what will be the accurate prediction of our current market rates and which will be the better option, fixed or variable?
Is using bond rates to predict where the current overnight rate is heading accurate? Honestly, no.
Using the expert’s opinion to predict the overnight rate isn’t going to be accurate either.
Projecting which mortgage will win over five years “can be hard when the market is priced to reflect expected changes,” Kavcic says. He says you’re usually better off focusing on factors you know, like the “applicant’s financial situation and tolerance for payment risk.” This includes the borrower’s five-year plan, their prepayment likelihood (given prepayment penalty differences), and so on.
Rates are cyclical because the economy is cyclical. As a result, the prime rate usually reverts to its mean after being significantly above average. There is always the exception. The late 70’s to early 80’s is a prime example of this.
One can argue that Canadians are over-leveraged and, therefore, rates can’t go up significantly; remember, that magnitude is only one factor. Time also matters and high rates could stay with us longer than expected, especially if there’s another inflation shock.
Inflation could persist longer than anticipated, thanks to inflation disconnect, high energy prices and trade disruption, which means there’s a chance that market-rate expectations may be too low.
To make it through the coming months-maybe years- we may need to look at our view of variable vs fixed differently?
Perhaps we shouldn’t be focusing on “the chicken or the egg” or “fixed vs. variable.”
It may be time to consider a diversified mortgage product, such as a hybrid mortgage. A hybrid mortgage is a home loan with a fixed interest rate for a specific period, after which the rate adjusts periodically for the remaining loan term. Diversity in your mortgage may solve the problem of potential market rate instability. It may be a way to protect your assets in what could be troubling times. As with any mortgage product, it is essential to discuss with your advisor whether a specific product will work for your mortgage needs.
Whether you are purchasing, renewing or refinancing your mortgage, come work with a qualified and knowledgeable broker to have an enjoyable and stress-free mortgage experience.