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Canadian Borrowers Gird Themselves for Another Surge in Rates

Many Canadians anticipated that mortgage rates would reach their peak this year, considering the steep rate hikes, a highly leveraged consumer base, and a significant 530 bps drop in inflation. However, economic models and long-term rate forecasts often fail to account for the unexpected twists and turns, such as:

  • Surging oil prices, with WTI crude recently hitting $95 due to supply shortages and unrelenting demand.

  • An unprecedented increase in bond supply fueled by excessive government spending on both sides of the border.

  • A record influx of 1.2 million new Canadians in just one year, resulting in increased pressure on housing, services, and infrastructure.

  • A plethora of other curveballs, including global yield increases driven by the Fed's quantitative tightening, Japan's yield control policy shift, the belief that the U.S. has avoided recession, ongoing labor shortages in critical sectors, decarbonization efforts, onshoring trends, and more.

Interestingly, despite expectations that Bank of Canada rate hikes would dampen CPI growth, the 3-month average core inflation rebounded by 100 bps to reach 4.5% last month.

Average Core Inflation
Average Core Inflation (Courtesy of Capital Economics)

While the possibility of a recession still lingers, these aforementioned catalysts are diverting bond yields and mortgage rates from the expected trajectory. Unfortunately, this upward deviation could lead to solvency concerns for various groups, including:

  • Consumers barely holding on

  • Non-investment grade corporate borrowers

  • Smaller to mid-size banks in the U.S.

Regrettably, high rates are proving ineffective at swiftly curbing domestic inflation and countering external factors like an oil shock.

​Noteworthy Fact: Historically, oil prices tend to reach extreme levels before supply can catch up to restore market equilibrium, a process requiring significant investment and time.

The unexpected "steepening of the yield curve due to higher long-term interest rates is atypical for this stage in the economic cycle," as highlighted by CIBC Capital Markets in a recent report.


This narrative has played out before, where the market suddenly realizes it has misjudged the situation. Without giving away the ending, the usual result is a surge in yields as investors lose confidence in their expectations of Fed rate cuts, and weaker investors are compelled to exit their positions, triggering a decline in bond prices and a simultaneous increase in bond yields.


The Impact on Borrowers

Stressed Borrower

Numerous homeowners find themselves caught in a financial conundrum, torn between their mortgage obligations and uncertain future prospects. For some, the choice lies between riding out the wave of rising rates or resorting to placing a 'for sale' sign in their front yard.


Many individuals hold onto a wishful prayer, hoping that various factors will align in their favor. These include a halt to the relentless surge in oil prices, fiscal restraint from Ottawa and the U.S., temporary immigration slowdowns, reduced trade tensions, and a peaceful resolution to the Ukrainian conflict. It's quite an extensive wish list, to say the least.


However, banking solely on hope is a precarious strategy. We cannot rely on the above-mentioned factors, at least not until the year's end.


Therefore, it's likely that interest rates will continue their incremental ascent. Furthermore, inflation is poised to rise, at least in the forthcoming report, and potentially in the subsequent November and December releases (scheduled for December and January, respectively).


Considering the less-than-pleasant numbers anticipated in StatsCan's next month report (CPI data is set for October 17), the Bank of Canada may contemplate another rate hike. Failing to do so could endanger its battle to manage inflation expectations, resulting in dire consequences for both the central bank and borrowers alike.


In light of these potential developments, borrowers must brace themselves for this possibility. Up until now, there has been a fixation on headlines projecting future rate cuts over the next year. Media outlets, including this one, The Globe and Bloomberg, continue to report market expectations, not due to delusions about their infallibility, but because people are keen to understand how the market is interpreting the latest data.


However, sometimes it becomes necessary to pivot and prepare for an extended period of unfavorable circumstances. The present moment calls for such a shift in perspective.


Sustaining a Balanced Viewpoint

Canada's Prime Rate

Let's be honest; economic growth is expected to decline. It's likely that two years of above-average rates, compared to the 5-year average, will slow spending and bring inflation back in line... if global factors like oil prices cooperate.


The market seems to agree. Yield inversion, an indicator of a gloomy economic outlook, is at its most extreme since 1990. Negative yield spreads often precede recessions by a year or two, and Canada's 10-year-2-year spread has been inverted for about a year.


While there's potential for yields to climb further in the short term, RBC Capital Markets suggests that "over the medium term, macroeconomic forces will likely prevail and push yields lower."


CIBC Capital Markets echoes this sentiment, stating, "Deteriorating fundamentals will always lead to the same outcome – lower yields." And if there's any silver lining, it's that a more substantial economic downturn requires more aggressive rate cuts.


But for now, we need to navigate through this year and prepare for potential challenges ahead.

 

Economic Sweet Spot

In an unexpected turn of events, fixed rates have reached their highest levels in 16 years. This has led many borrowers to admit defeat in their attempts to forecast interest rates, as well as those of experts. Consequently, an increasing number of borrowers are now favoring longer-term mortgages with lower initial rates.


According to feedback from lenders, the 3-year fixed mortgage remains the most popular choice among borrowers. However, if we assume just one more interest rate hike, simulations based on the latest forward rates indicate the following outcomes:

  • Variable rate mortgages will outperform all other terms for insured mortgages.

  • 1-year fixed rates will outperform all other terms for uninsured mortgages.

It's important to note that these results are based on a specific point in time, relying on the CORRA forward curve as the data source (CanDeal DNA), nationally available rates at their lowest, and certain standard assumptions (e.g., renewal rates mirroring historical average spreads, borrowers incurring standard switch costs, etc).

 

Latest Renewal Statistics

Just recently, National Bank delivered a stark message: an astonishing 85% of its fixed-rate borrowers will confront higher rates during the 2024-2026 renewal period.


To make matters even more challenging, Desjardins shared a report that offered this rather gloomy outlook: "If the current forward pricing materializes, first-time renewal for variable-rate borrowers will result in payment increases of over 50% in the upcoming years."

Market-implied rates

According to the data, the most affordable variable rate accessible across the nation in February 2022 (just before the Bank of Canada initiated its series of rate hikes) stood at 1.39%. If we fast forward to the present day, that very same borrower now faces a 6.14% rate.


National Bank reports that individuals with floating-rate loans have already experienced monthly payment increases of $600 in Quebec and $1,200 in Ontario (Bloomberg).


What's to Come

"Our view continues to see interest rates lower than currently priced in for the end of next year and beyond to help ease the sting of mortgage renewals," Desjardins stated.


Nevertheless, the market anticipates only a gradual reduction over the next two years, amounting to just 50 basis points of net relaxation compared to the present (refer to the chart below). And, excluding the timing aspect, we're not entirely convinced about the pace. As demonstrated in the previous prime rate chart, rate cut cycles of such sluggishness are rather unusual.

Forecast Curve

The market can't underestimate what it can't foresee. Inflation remains a factor that supports interest rates. Unless a crisis occurs, there's no hurry for the market to anticipate more rate cuts in the near term. It won't do so until inflation begins to move in a favorable direction and the threat of rising oil prices diminishes. Borrowers should prepare for a waiting game that could last for months before substantial rate reductions are factored in.


If you're seeking guidance or assistance with mortgage-related matters in these uncertain times, don't hesitate to reach out to me. I'm here to help you navigate through the complexities and make informed decisions for your financial well-being.

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