SOURCE: ROBERT MCLISTER, SPECIAL TO THE GLOBE AND MAIL PUBLISHED: JANUARY 26, 2023
Canada’s central bank head, Tiff Macklem, says he’s not even thinking about rate cuts.
But the bond market is.
Bond traders are projecting the Bank of Canada will start easing interest rates this fall. That, and falling inflation, have people thinking that prime rate has topped out.
Whether it is or not, I won’t hazard a guess. The bond market does the that for us, and it’s been more right than the Bank of Canada when it comes to inflation forecasting.
Meanwhile, those with variable mortgages are paying rates we haven’t seen since the dawn of this century. And now they’re wondering what to do with their lofty interest obligations.
Well, assuming one plans to stay in their home and can afford their payments, the two most obvious options are: (A) do nothing and ride the variable-rate wave, or (B) break one’s variable mortgage early and move into a cheaper fixed rate.
Let’s evaluate each option:
Option A: Sit on your hands
People don’t get a variable rate unless they’re prepared for rate volatility. Or at least, they shouldn’t.
Well, we got that volatility alright.
Prime rate has soared 2.7 times since March 1, 2022 – an all-time record among proportionate rate increases. And it did that in less than 12 months.
Even at the absolute nosebleed rate peak in 1981, when prime was 22.75 per cent, it only rose 1.9 times over 12 months.
If Canada’s economy were a jumbo jet, the BoC has almost cut the engines and extended maximum flaps. We’re in danger of hitting stall speed pretty darn quick.
When inflation does ease and the economy starts descending, the BoC will be forced to hit the throttle again – i.e., cut rates. Whether that happens in six months, a year, or more – we just don’t know.
The bond market thinks it knows, however. And if it’s right, then riding out a costly variable mortgage will make sense.
You’ve got to run the numbers based on your own situation and risk tolerance, but here’s an example.
Suppose you’re a well-qualified borrower with an uninsured variable mortgage at 5.7 per cent – i.e., at prime minus 1 per cent. The lowest nationally available one- and two-year fixed rates are currently 5.74 and 5.54 per cent, respectively.
In this case, it makes virtually no sense to pay the required three-month interest penalty ($1,425 per $100,000 of mortgage) to break that variable mortgage.
You’d need short-term rates to dive far more than one percentage point to make it worthwhile and offset the penalty, switching costs and aggravation.
Even if you have a subpar variable discount like prime minus 0.4 per cent, or you find an insured one or two-year fixed at the nationally leading rate of 4.64 per cent, it still makes little sense to break and refinance. The best bet is to see how rates shake out in the months ahead and re-evaluate.
Option B: Break your variable mortgage early and move into a cheaper fixed rate
We’re starting to see five-year fixed rates approach levels that are one percentage point lower than most existing variable rates. But only a minority are lining up to lock in for five years at rates like 4.5 per cent and up – ahead of a likely rate-cut cycle.
Doing so makes little sense historically unless you’re extremely risk-averse – or you think it’s 1978 again.
Could this be another 1978? Back then, central banks thought they had inflation licked, were horribly wrong, and rates blasted off again.
Anything’s possible. But historically such outcomes are a low probability. When prime rate is more than 20 per cent above its five-year average, there’s less than a one in seven chance that locking in long-term is the right move. Albeit, there have been so few comparable periods that the confidence level for such probabilities are not statistically conclusive.
Here’s the long and short of it. Manage your variable based on your cash flow, safety net and stomach for risk. And get some one-on-one advice if you’re not sure.
If you’re a floating-rate borrower with enough money to wait out the Bank of Canada, the best advice is probably to play the anecdotal historical odds, play the bond market’s implied odds, and ride that bucking bronco variable till the rodeo’s over.