A deep dive into rates - where they come from, what they mean, and where (I think) they’re heading.
I get questions all day, every day about the types of rates available, how they work, and which is best. So pour a fresh cup of coffee, get comfortable and read on to learn all the basics you might want to know about inflation, the Bank of Canada, and how the rate environment works as a result.
With the next Bank of Canada rate announcement coming up this week (on July 13th), questions around the current rate environment in Canada are ramping up - and that’s understandable! There is so much uncertainty about what’s happening in the market, even among real estate professionals and economists. So of course for most of us who aren’t immersed in this stuff all day every day, trying to navigate what to expect can be overwhelming. So I thought I would sit down and put together a road map of what is currently informing Canadian inflation, how interest rates shift as a result, and where our major financial institutions glean their basis for the rates we see as consumers. In this post we’ll cover the basics around:
Where inflation comes from (and what it actually means), and how it affects us as consumers and borrowers
The difference between overnight rate, prime rate, and variable rates
How fixed rates are set and how the 5 federal bond market informs them
The bottom line of the fixed vs variable debate
On inflation.
Before we can dig into the origins of variable rate, we have to take a look at inflation. It’s a buzz word that we all hear a thousand times a day right now - but do we know what it really means, other than expensive gas and extra-large grocery bills?
Simply defined, inflation is the decline of the purchasing power a currency. Inflation rate (the number we see rising in the news) is the rate at which that decline is happening. Typically we see inflation go up when there is an increased consumer demand (or more money to spend) and not enough supply to fulfill it. According to CIBC Deputy Chief Economist, Benjamin Tal, there are currently 4 key sources of the record high inflation we are experiencing today: energy, supply chain, rent inflation, and labour market/wages. It certainly doesn’t take an economist to recognize how all of these factors have played into our current reality as we continue to experience COVID-related supply and labour disruptions. Even as we move into the endemic phase the we are seeing continued labour shortages, manufacturing hold-ups and shipping delays - not to mention the removal of Russian oil from the global market.
In a nutshell, all of these factors have led to a 40 year record high inflation rate of about 7% in Canada this spring and ideally, economists prefer that rate to stay around 2%. So what is there to be done about it, other than magically kick-start the supply chain? Well, this is where the Bank of Canada’s overnight rate comes in.
Some important definitions.
Chart: the average rate of inflation against the average variable mortgage rates in Canada since 1975.
Overnight rate.
The overnight rate is a federally-mandated monetary policy set by the Bank of Canada periodically over the year. Essentially, it is the rate that controls how expensive it is for banks to borrow money. So, as the overnight rate goes up, borrowing costs the banks more and in turn those higher costs get passed on to borrowers in the form of higher interest rates. As a result money gets more expensive, consumer behaviour slows and (if it goes to plan) supply replenishes, slowing inflation.
Prime rate.
Prime rate is set by the big banks (BMO, Scotiabank, CIBC, RBC and TD) in immediate response to the overnight rate and is used to set rates on many types of loans including variable rate mortgages. The banks can set their own prime rates but they tend to use the same - it’s currently 3.7%, but will likely increase this week when the overnight rate does the same. If you have a variable-rate mortgage, HELOC, student loan, or line of credit then a change to prime will affect you right away.
Variable rates.
The variable rates you see as the borrower are set by lenders at a rate of prime less a percentage discount. This discount is set based on the lender’s own strategy, credit market conditions and competition. So if your contract rate is, for example prime - 0.8% your rate will be 2.9% today and if prime goes up to 4.45% this week as expected, so too will your rate - to 3.65%. Keep an eye out because typically as the gap between fixed and variable rates becomes smaller, the discounts offered become larger.
To recap so far: Inflation occurs when there is a surplus of money to spend and not enough supply. Between the supply chain and labour issues stemming from COVID, the unrest in the oil market and consumers re-entering the market, we are seeing record high inflation rates. To combat this, the Bank of Canada is putting high pressure on the market by increasing its overnight rate incrementally, and quickly. The intention is that as money becomes more expensive to borrow, consumer behaviour will slow down and supply will increase, slowing inflation. A potentially unfortunate side effect is that the borrowing power of home buyers decreases as interest rates go up. But we’ll chat more about that next week!
Average fixed vs average variable mortgage rates in the month of June since 1996
So what about fixed rates?
Fixed rates, which have been historically low for the past 2 years, are not set in response to the BoC rate. But rather, they are based on 5 year Government of Canada bond yields. A government bond is a popular, secure investment which essentially Canadians lending money to the government and interest is paid back - this interest is the “yield.” As the price of the bond decreases, the yield increases and as the yield increases, so do fixed rates. Typically to set fixed rates, lenders add 1-2% to the 5 year yield. This difference is called the “rate spread.”
So, for example the 5 year benchmark bond yield today (July 11th, 2022) is 3.19%. This is to say that the return an investor will get by holding onto a bond for 5 years will be 3.19%. Fixed rates, as a result are at around 4.35%, so the rate spread is about 1.6%. If you are interested in following the 5 year bond yields, bookmark this link.
Earlier in the pandemic, Canadians were selling off their bonds for income which was driving up the yields and, as a result, driving up fixed rates. So to ease some of that pressure, the Bank of Canada enacted a process called quantitative easing in which it bought large quantities of bonds, synthetically lowering yields to keep rates down. This is why we were seeing fixed rates below 2%. Now, as the economy is back in motion and the BoC’s main objective is to not only slow inflation but prevent deflation they have switched to a process of quantitive tightening by actively selling previously purchased bonds (or letting them roll off the balance sheet) to release some of that downward pressure. As a result, we are seeing bond yields increase and fixed rates following suit.
So to recap: Fixed rates are impacted by inflation and the overall tone of economy, but are not directly impacted by the Bank of Canada’s overnight rate, which is set to increase again later this week. Both the overnight rate and quantitative tightening are tools that the BoC utilizes to get inflation under control and create a more affordable environment for Canadians.
So which option is more affordable?
After learning about where rates come from, it’s still hard to determine which is going to be the best and most affordable option for you, right? While there is no perfect answer to that question and the situation is going to be different for everyone, there are numbers we can analyze and significant research to how us that historically, variable rates do end up saving us in the long run.
In 2001, and again in 2008, distinguished York University economist Dr. Moshe Milevsky published a longitudinal study that concluded that, based on data from 1950 to 2007, the average Canadian could expect to save interest 90.1% of the time by choosing a variable-rate mortgage instead of a fixed. Variable mortgages typically let people shave over a year off their amortization. (See a great synopsis of Dr. Milevsky’s work here).
However, Dr. Milevsky and many other prominent economists have noted in this rate environment that the best rate for you depends on your finances, your needs, and your risk-aversion.
The moral of the story.
At the end of the day, it’s important to understand where your mortgage rate comes from. While not everyone needs to be an economist, it is prudent as a homeowner to have at least a basic understanding of what influences your mortgage rate and what to watch for since it is your money leaving your pocket in question. However, the most important thing is working with a professional you trust who not only has a solid understanding of the landscape, but also has your best interests at front of mind.
And to answer the question I get asked the most - do I think the sky is going to fall and cause a 1980s level recession and doom us all? No, I don’t. Sure, inflation is high and the Bank of Canada may overshoot rate and bond market control as solutions in the short term. But our monetary policies are much stronger, and our economy much more resilient than it was then. I think that the best path forward is to invest prudently, shop when it’s comfortable for you, and make choices to set you up for the long term vision rather than worrying about short term fluctuation.
Stay tuned next week to learn more about the prime rate and market projections and how we can best set ourselves up for success as the market changes.
