Variable Rates Rise Again
Bank of Canada has raised their overnight rate by 1.00%, bringing it to 2.50%. Which for most lenders will likely increase their Prime rate to 4.70% from the previous 3.70%.
This change will have an impact on those with a Variable Rate Mortgage or Home Equity Line of Credit. It will mean a $56 a month payment increase for every $100,000.
Those with a fixed rate mortgage won't be affected by raising rates until they come up for renewal.
What is the Bank of Canada Overnight Rate?
The overnight rate is generally the interest rate that large banks use to borrow and lend from one another in the overnight market.
The Bank of Canada holds this Key Lending rate. They might lower it to encourage borrowing and spending OR they may increase it to curb inflation and debt levels.
Major lenders typically raise their prime rate when there is a hike. Thats the number they use to set interest rates for loans and mortgages.
Unlike a fixed rate where one is locked in to their rate, those in a variable rate will be affected by these changes. Home owners with fixed rate mortgages won't be affected until they have to renew.
Should I lock into a Fixed Rate now?
Historically variable rates have shown to save you more money in the long run.
A few things you should consider before locking into a Fixed rate is:
Are you planning to sell your home within the next 3yrs? Then we would highly recommend you stay in your variable rate mortgage.
Can your budget handle a payment increase if rates go up?
Will you be putting extra money down on your mortgage each month? If so, the savings from a variable rate can help you pay down your mortgage faster.
If you are considering locking in, give us a call to discuss first. We have a fun little calculator to help you forecast your savings if you decide to stay with your variable rate.
Source: First National - one of Canada's largest non-bank mortgage lenders, offering both commercial mortgages and residential mortgage solutions.
Today, the Bank of Canada increased its overnight benchmark interest rate 100 basis points to 2.50% from 1.50% in June – the largest single increase in almost 25 years. This is also the fourth time this year that the Bank has acted to tighten money supply to combat the possibility of an entrenched inflationary cycle, although previous moves were much smaller (0.25% in March and 0.50% in each of April and June).
The Bank characterized this progressively larger increase as a way to “front-load the path to higher interest rates,” a clear signal that it is concerned that elevated inflation will become entrenched without affirmative action and that more rate hikes are almost certainly on their way.
With this latest increase, the Bank Rate rises to 2.75% and the deposit rate increases to 2.50%.
These are the highlights of today’s announcement.
Inflation at home and abroad
Inflation in Canada is higher and more persistent than the Bank expected in its April Monetary Policy Report, and will likely remain around 8% in the next few months
Global factors including the war in Ukraine and supply disruptions are the biggest drivers, but “domestic price pressures from excess demand are becoming more prominent”
Surveys indicate more Canadian consumers and businesses are expecting inflation to be “higher for longer,” raising the risk that elevated inflation becomes entrenched in price- and wage-setting; “if that occurs, the economic cost of restoring price stability will be higher”
The July outlook for Canada has inflation “starting to come back down later this year, easing to about 3% by the end of next year and returning to the 2% target by the end of 2024”
Global inflation is higher and accordingly, many central banks are also tightening their monetary policies
Canadian and global economies
As a result of tighter financial conditions, economic growth is “moderating” and will continue to do so as tighter monetary policy works its way through the economy; when combined with the resolution of supply disruptions, the Bank believes this change “will bring demand and supply back into balance and alleviate inflationary pressures”
As a result, the Bank now expects Canada’s economy to grow by 3.5% in 2022, 1.75% in 2023, and 2.5% in 2024 and for global economic growth to slow to about 3.5% this year and 2% in 2023 before “strengthening to 3% in 2024”
Canadian labour markets are tight with a record low unemployment rate, widespread labour shortages, and increasing wage pressures
With strong demand, Canadian businesses are passing on higher input and labour costs by raising prices
Domestic consumption is robust, led by a rebound in spending on hard-to-distance services, while business investment is solid and exports are being boosted by elevated commodity prices
The Bank estimates that Canada’s Gross Domestic Product grew by about 4% in the second quarter
In the United States, high inflation and rising interest rates are contributing to a slowdown in domestic demand
China’s economy is being held back by “waves of restrictive measures” to contain COVID-19
Canadian housing market
As growth in Canada is expected to slow to about 2% in the third quarter as consumption moderates, the BoC is now projecting that housing market activity will “pull back following unsustainable strength during the pandemic”
Along with noting that its Governing Council decided to “front-load the path to higher interest rates” with today’s 100 basis point increase, the BoC also said it “continues to judge that interest rates will need to rise further, and the pace of increases will be guided by the Bank’s ongoing assessment of the economy and inflation.”
The Governing Council stated that it is “resolute” in its commitment to price stability and will continue to take action as required to achieve its 2% inflation target. The message to the market is clear: inflation must be corralled and higher interest rates are to be expected.
September 7th, 2022 – the date of the BoC’s next policy announcement
Interest rates are still rising,
but investors should start preparing for when they come back down
Variable rates will likely be a benefit once again in the midterm
The Bank of Canada over the past 30 years has had six periods of interest-rate hikes, ranging from 1.25 to 3.2 percentage points, before this most recent set in 2022.
The one thing they all had in common was that it didn’t take long for each of them to be followed by a period of declining interest rates, ranging from 1.25 to 5.125 percentage points.
Let’s do a quick review of the six rises and falls since 1994.
In October 1994, the Bank of Canada’s overnight rate was 4.94 per cent. Over the next four months, it rose significantly to 8.125 per cent — a rise of 3.2 percentage points. Over the following nine months, it declined to 5.94 per cent, and one year later it was sitting at three per cent. This was a large rise and fall historically, but it outlines how quickly rates can rise and how steep the ultimate decline can be.
One logical reason for this is that rate rises are meant to slow down the economy, and rate declines are meant to boost the economy. There is a general view that the increases typically start too late, and so rates are still rising after the economy is already slowing. Once they really start to take effect, the impact can be too much, and the central bank has to do a quick about-face.
The next period of rate adjustments saw the overnight rate rise to 5.75 per cent from three per cent over a 15-month period in 1997 and 1998. The subsequent decline wasn’t as steep, but it did drop over the following nine months to 4.5 per cent in May 1999.
In October 1999, the rate was still 4.5 per cent, but then rose to 5.75 per cent by May 2000. One year later, it was back to 4.5 per cent and it was all the way down to two per cent by January 2002.
Over a 25-month period from March 2002 to April 2004, the rate went from two per cent to 3.25 per cent and back to two per cent.
During a relatively prosperous time, the rate rose to 4.5 per cent in July 2007 from 2.5 per cent in August 2005. But the financial crisis of 2008 started to rear its head, and rates fell first to three per cent by April 2008 and all the way to 0.25 per cent a year later.
More recently, the rate in June 2017 was at 0.5 per cent, rose to 1.75 per cent by October 2018, and then dropped to 0.25 per cent by March 2020 when COVID-19 began.
What does this mean for today? So far, we are 1.25 percentage points into an interest-rate-hiking cycle. Some think there are another one or two more points in front of us. Others think it will be less than that. What if the overnight rate goes from 0.25 per cent (where it was in February 2022) to 2.75 per cent? For many of us, that would be a bad thing because our borrowing costs would be meaningfully higher. However, if we were somewhat confident that rates would soon be heading down from there, would that ease our concerns?
History suggests this will happen. The six hiking cycles averaged 13 months in length. The current one is four months in. The six declining cycles began on average 5.7 months after the hikes stopped, but it happened within three months in three of the six scenarios. The average interest rate hike was 1.95 percentage points and the average decline was 2.85 percentage points.
History can be a guide, but certainly not a clear roadmap. If all we did was simply look at the averages here, it would suggest that we have another 0.7 percentage points of rate hikes, which would take another nine months to reach. Interest rates would then start to decline by September 2023 and eventually drop all the way back to 0.25 per cent (or more if it was possible).
Of course, each scenario is different, so things won’t simply follow these averages. The causes are different and the starting point on interest rates is different. That said, this cycle has been very repetitive over the past 30 years.
If I had to guess, I would expect the rate-hiking timeline will be shorter than 13 months, but that rates will move up by more than just 0.7 percentage points. I believe the start of the rate declines might happen sooner than September 2023. The implied policy curve for Canada currently suggests that rate hikes will peak in six months and then start to decline with the following year. This doesn’t mean that this is a fact, but it shows that even today, the implied policy rate is giving some indication of the same cycle we have seen several times before.
Another clue as to why the next cycle might look like the past is that even the Bank of Canada has said one of the reasons for increasing rates is so it will have some greater tools and leverage to help the economy by lowering rates if we go into a recession or something similar.
If that is the future, what does that mean for investors and borrowers?
Variable-rate borrowers will feel more pain in the near future, but it isn’t a one-way road. Variable rates will likely be a benefit once again in the midterm.
If you are looking at buying guaranteed investment certificates, annuities or bonds, it may still be a little early to lock in or invest, but there will likely be a sweet spot to do so later this year or in the first half of next year.
High inflation and higher interest rates seem like the obvious situation today, but this may shift in the not-too-distant future, so don’t go overboard with this investing thesis as it can turn on you. You want to be nimble.
The key message here is that we should not panic about runaway rate hikes. They will continue to rise, but it is also very likely that we will see rates fall shortly after the hikes stop. Maybe this rollover will happen by the end of this year or at some point in 2023, but being prepared for this scenario will allow for some investment opportunities and debt opportunities to be maximized.
Ted Rechtshaffen, MBA, CFP, CIM, is president and wealth adviser at TriDelta Financial, a boutique wealth management firm focusing on investment counselling and estate planning. You can contact Ted directly at firstname.lastname@example.org.