How Will Rising Rates Affect Mortgage Holders

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Variable-rate mortgage holders have something to celebrate - on Wednesday, January 26, the Bank of Canada surprised markets by holding its key interest rate at 0.25%, though it did stress that interest rates will gradually rise going forward. The central bank chose not to raise rates despite climbing inflation and a stronger-than-expected economic recovery. Ahead of the Bank's meeting, Bloomberg data showed roughly a 70% probability of a rate hike in January.

In its statement, the central bank acknowledged that the economic downturn has been fully offset, though Omicron is now weighing on growth. We felt it was appropriate to take a measured set of steps, said Bank of Canada Governor Tiff Macklem. Today's decision is consistent with the measured approach we've taken throughout this pandemic. It also reflects the fact that Omicron is affecting the economy.

Considerable uncertainty remains, and reopening the economy while Omicron continues to weigh on economic conditions has proven to be a difficult task. By staying clear and measured, we're genuinely trying to cut through the noise so that monetary policy serves as a source of confidence, not another source of uncertainty, he added. Whether the Bank of Canada decided a new wave of the pandemic wasn't the right moment to begin a hiking cycle, or simply wanted to formally close out its pause before pulling the trigger, one thing is beyond doubt: rate hikes are coming, said Avery Shenfeld, chief economist at CIBC Capital Markets.

Another factor that may have influenced this decision, according to Frances Donald of Manulife Investment Management, is that the Bank had not previously signaled to markets that the economy's productive capacity had fully recovered. Donald noted that monetary policy works with a lag, meaning the Bank of Canada could end up in a situation where the coming rate hikes coincide with a natural slowdown in the economy.

Meanwhile, on that same day, January 26, the US Federal Reserve left its target rate range unchanged (0-0.25%), as expected. Chair Jerome Powell said the central bank is prepared to raise rates in March and hasn't ruled out taking similar action at every subsequent meeting in order to keep inflation in check.

Although the Bank of Canada didn't raise its key rate this time around, it remains fairly clear that rates will rise in the months ahead. The Bank of Canada's next meeting is scheduled for March 2, 2022. So the real question now is how aggressively the Bank will raise rates during this cycle, and what that will mean for mortgage holders.

We're already seeing financial institutions in Canada start raising their variable and fixed rates in anticipation of a central bank hike. At the same time, some banks haven't raised their rates yet. So if you'll need a mortgage within the next 120 days, your best bet is to apply soon and lock in today's rate. Fixed rates on insured mortgages currently range from 2.59% to 2.79%, whereas just a couple of months ago clients could get rates below 2%. We're also seeing some of the major players in the mortgage market trim their discounts (off the prime rate) on variable rates by 0.10% to 0.20%.

When the Bank of Canada raises its overnight rate by 0.25%, a homeowner with a five-year variable-rate mortgage will pay roughly $12 more per month for every $100,000 of debt.

According to BMO senior economist Robert Kavcic, the mortgage market won't be able to hide from rate hikes any longer this year. Canadian mortgage rates are like a coiled spring that's about to be released - it's just not clear by how much, he explained. Looking at the five-year fixed rate market, government bond yields could point to a further increase of roughly 0.50% or a bit more. On the variable rate side, an increase of 1% or more from the Bank of Canada is possible over the course of this year.

Ahead of January's decision, the market was pricing in as many as seven rate hikes by the end of 2022, according to Bloomberg. That could push the central bank's overnight rate to 2%, with the prime rate - which variable-rate mortgages are based on - reaching 4.20%.

Some economists, however, consider this too sharp and hasty a conclusion.

Stephen Brown of Capital Economics finds these market forecasts fairly strange, since they imply the Bank of Canada will raise rates faster and further than the US Federal Reserve, even though our southern neighbours are dealing with higher inflation.

What's more, the structure of the Canadian economy, with its outsized dependence on a rate-sensitive housing sector, differs significantly from that of the US. In Capital Economics' view, these risks will push the Bank to pause its hiking cycle at around 1.5%, nearly 0.50% below current market expectations.

Market traders are pricing in roughly six rate hikes over the next 12 months, but that may end up being somewhat more than what actually materializes, says Vinayak Seshasayee of Pacific Investment Management Co. (PIMCO). PIMCO expects the central bank to raise rates only four times this year - and it holds the same expectation for the US Federal Reserve. Macklem has other tightening tools at his disposal as well, such as reducing the volume of government bonds held on the Bank of Canada's balance sheet, Seshasayee says. There are also additional factors that will keep the Canadian government from raising rates too high or too fast. In Canada, we've recovered most of the jobs lost, but if you look at the labour market from a different angle, there are still significant gaps - particularly when you look at total hours worked and overall productivity, Seshasayee adds. On top of that, Canadian households carry high levels of debt, which makes the economy especially sensitive to rate increases.

If you're thinking about buying a property, or you have a variable-rate mortgage and aren't sure what to do given the current situation, give us a call and we'll help you figure out the right move.