The Next Rate-Hike Cycle and How to Prepare for It
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This month, our wonderful Canada celebrates its 154th birthday! Restrictions from the third wave of the coronavirus are gradually being lifted, and step by step, we're returning to normal life. Against the backdrop of prolonged restrictions and lockdowns easing, Canadian spending is on the rise, as household savings have grown significantly. This is exactly why investors expect the next tightening cycle from the Bank of Canada, expected to begin in 2022, to push interest rates above the previous cycle's peak for the first time in decades.
Across all four major hiking cycles since the early 1900s, the central bank's key interest rate has always stayed below the peak of the previous cycle. But that could change in the cycle ahead, since the historic scale of government spending worldwide raises the odds that the recovery from COVID-19 will be stronger than after previous downturns.
The Canadian government will spend $101 billion (roughly 5% of GDP) on economic stimulus over three years. US President Joe Biden has proposed investing trillions of dollars in infrastructure. Canada sends roughly 75% of its exports to the US.
A higher peak rate could give the Bank of Canada more room to fight the next downturn. It could also reshape the economy, increasing the appetite to save and invest rather than borrow. In recent years, Canadians have taken on debt aggressively to buy into one of the hottest real estate markets in the world.
The Bank of Canada has signaled that it could begin raising rates from a record-low 0.25% in the second half of next year, well ahead of the US Federal Reserve, which isn't planning to start raising rates until 2023.
According to market analysts, the expected hiking cycle could peak at roughly 2% within five years, above the previous cycle's peak of 1.75%.
"We're seeing a lot more fiscal policy right now, and to me, that changes everything," says Andrew Kelvin, Chief Canada Strategist at TD Securities. In the last cycle, Canada was part of a global cycle in which no central bank really managed to reach what it could call a neutral rate.
The neutral rate is the level reached when the economy is running at full capacity and inflation sits right at target. It's a signpost for which direction rates are likely to move. The Bank of Canada's current estimated neutral rate ranges from 1.75% to 2.75%.
According to the central bank's own calculations, Ottawa's support for households during the pandemic, combined with reduced spending by Canadians stuck in prolonged lockdowns, boosted savings by roughly $180 billion in 2020.
Those extra funds are likely to fuel higher consumer spending over the next 10 years, which could push the rate cycle's peak higher than the last one, potentially even above the neutral rate itself. That's the view of Royce Mendes, senior economist at CIBC Capital Markets. All of that money has to go somewhere eventually, he says. It's not going to sit in household bank accounts for decades. Thanks to today's extremely low rates, on average 61% of the first mortgage payment now goes toward paying down principal.
Back in the early 2000s, that figure stood at 26.5%. The shift looks even more dramatic when you go back to the 1990s average of 11.9%. In the 1980s, it was just 4.6%.
As a result, borrowers are managing to build up far more equity in their homes in a much shorter time, as long as interest rates stay low. Homeownership represents an extremely aggressive form of forced savings, according to the annual consumer report from Mortgage Professionals Canada. As a result, even setting aside the effect of rising prices, equity builds up in a home very quickly, the report's authors add. This excellent net affordability explains why market activity in Canada remains so strong, and why most Canadians still consider homeownership more financially advantageous than renting, even with home prices climbing rapidly and the burden of mortgage payments and interest.
Low interest rates haven't just let borrowers pay down their mortgages faster, they've also helped keep affordability reasonably manageable, even as prices climbed an average of 38.4% over the past 12 months.
That said, rates won't stay low forever.
No one can predict exactly how large the increases in the Bank of Canada's next cycle will be, but markets are pricing in at least eight 0.25% hikes over the next five years. That would bring Canada's overnight rate to 2.25%, 2% above today's record-low 0.25%.
If you have stable employment and recently locked in a mortgage at an extremely low rate, now is the time to start preparing for future rate increases. The simplest approach is to raise your mortgage payments to match a potentially higher future rate. Say you have a variable-rate mortgage at prime minus 1% (1.45% today), or a fixed rate under 2%. Call your broker or your bank and ask them to calculate what your payment would be at 2.5-3%. If you're comfortable with that new payment amount, set your payments at that level (most banks allow borrowers to increase their payments by 15-20% a year). Any extra money you're paying goes straight toward your principal, so by the time rates do rise, you'll be paying that higher rate on a smaller outstanding balance. If that adjustment would strain your budget too much, try switching to accelerated bi-weekly payments instead. That works out to one extra monthly payment a year, but it's a change that's a bit easier to absorb.
If you own property and have built up credit card debt or other loans, consider refinancing your mortgage to roll that high-interest debt into your low-rate mortgage. You'll be surprised how much extra room that frees up in your budget. You can put those savings toward paying down your mortgage faster, or simply enjoy a much healthier cash flow and breathe a little easier, free from the constant weight of high credit card interest. That said, check with your mortgage broker or bank first to find out the size of any prepayment penalty on your existing mortgage, so you can run the numbers accurately.