How Recent GDP Data Could Impact Mortgage Rates

We've just received the latest GDP data for both Canada and the United States, and in this blog post, we'll dive into how these figures might affect mortgage rates in the near term. Additionally, we'll explore the challenges posed by the mortgage stress test in Canada and the pressing issues facing Canadian mortgage borrowers.

Canadian GDP Sees Sluggish Performance

Last week, Statistics Canada confirmed that our Gross Domestic Product (GDP) displayed no growth in July, following a 0.2% decline in June. Moreover, the estimate for August indicated a meager 0.1% expansion in our economy. These statistics prompted adjustments in the bond futures market, leading to reduced expectations of another interest rate hike by the Bank of Canada (BoC) this year. This trend aligns with the market's sensitivity to economic data releases.

The sluggish momentum in our GDP growth underscores the impact of the BoC's previous interest rate hikes, which are now becoming discernible. It also suggests that the savings buffers created during the pandemic, enabling consumers to manage higher costs while maintaining spending, are gradually depleting.

However, it's essential to note that sluggish economic growth alone won't suffice to bring inflation back in line with the BoC's 2% target. The overarching theme is that we have a considerable distance to cover before reaching that objective.

Strong and Steady US GDP Growth

In stark contrast, recent data reveals that the United States achieved a year-over-year GDP growth rate of 2.1% in the second quarter. The US economy is currently operating at a significantly more robust pace compared to Canada, driven by two key factors:

1. Productivity Surge: Productivity in the United States has shown remarkable improvement since the pandemic began, whereas Canadian productivity has steadily declined during the same period. The significance of this measure, particularly over the long term, cannot be overstated.

2. Household Debt Discrepancy: During the 2008 Great Recession, US households substantially reduced their debt levels, while Canadian households continued to accumulate debt, as indicated in the chart. This divergence in household debt-to-GDP ratios suggests that the US consumer may be less sensitive to interest rate hikes, potentially causing the US Federal Reserve to maintain higher policy rates for a more extended period than the BoC. This scenario could have repercussions on Canadian fixed-mortgage rates.

Fixed vs. Variable Mortgage Rates

Fixed mortgage rates in Canada are heavily influenced by Government of Canada (GoC) bond yields, often moving in tandem with their US counterparts. This synchronization may keep Canadian fixed mortgage rates elevated, even amid a weakening domestic economy.

Conversely, variable mortgage rates in Canada are not subject to the same constraints. They adjust in line with the BoC's policy rate, providing a more accurate reflection of domestic economic conditions.

Reevaluating the Mortgage Stress Test

As our economy decelerates and our housing markets cool down, it's time to reconsider some established practices. One such practice under scrutiny is the 2% inflation target. Some argue that this target is arbitrary and that a slightly higher target, around 3%, might be more suitable in the future.

The mortgage stress test is another policy tool under scrutiny given the evolving circumstances. While it made sense to qualify borrowers at rates close to long-term averages when mortgage rates were exceptionally low, the situation has changed. Mortgage rates have climbed above historical averages, and the BoC's policy rate remains in restrictive territory. The question arises: Is it still appropriate to qualify borrowers at rates 2% higher than their already elevated current levels?

While an immediate change to the stress-test rate isn't advocated, policymakers must navigate the housing market's momentum to combat inflation. There's also the issue of excess leverage in certain regional markets that heated up during the pandemic. However, the debate about reducing or altering the stress test will likely intensify, perhaps sooner than anticipated.

An Unjustifiable Policy: Renewal Borrowers' Dilemma

A notable flaw in our banking regulator's mortgage rules is the requirement for renewing borrowers switching to a different lender at renewal. They must be requalified at today's stress-tested rates, unlike borrowers who renew with their existing lender.

Initially designed to prevent excessive competition among lenders for highly leveraged borrowers, this policy inadvertently traps many borrowers with their existing lenders. This often forces them to renew at inflated rates. Despite criticism, the regulator has yet to address this anti-competitive policy and its impact on borrowing costs.

With today's stress-test rates exceeding 8%, more borrowers are unable to access competitive rates. This should increase pressure on our regulator to rectify this issue.

In Conclusion

While the five-year GoC bond yield showed minimal changes recently, a mid-week surge in bond yields led to further increases in fixed mortgage rates. Predicting when fixed rates will stabilize is challenging due to the strong upward momentum in bond yields. Therefore, those seeking a mortgage are advised to secure the best available rate today, as even a seemingly less favorable pre-approval rate could become highly competitive in the near future.

Variable-rate discounts have remained unchanged, and although the consensus suggests the BoC may have completed its rate hikes for 2023, uncertainty persists. The bond futures market's volatility, coupled with forthcoming employment reports from both the US and Canada, could trigger additional rate fluctuations.

The State of the Canadian Economy in Q2 2023

In the latest data released by Statistics Canada (StatCan) this morning, the Canadian economy experienced stagnation during the second quarter of the year.

Key Economic Figures for Q2 2023

StatCan reports that the Canadian economy contracted by an annualized rate of 0.2% in Q2 2023, a figure significantly lower than the Bank of Canada's earlier prediction of 1.5% growth. Additionally, StatCan revised the growth rate for the first quarter, reducing it to an annualized rate of 2.6% from the previously reported 3.1%.

Factors Contributing to Second-Quarter Weakness

A significant contributing factor to this weakness was a 0.2% decline in output in June.

Impact of High Interest Rates and Housing Prices

As expected, given the prevailing high interest rates and housing prices, investment in the housing sector continued to decline in the second quarter, primarily due to reduced new construction activity.

Consumer Spending and Its Trends

Consumer spending showed a modest increase of 0.2%, but this was the smallest uptick since the pandemic lockdowns in Q2 2021. Furthermore, the growth in real household spending slowed to 0.1% in Q2, compared to 1.2% in the first quarter, reflecting the significant impact of inflation and higher borrowing costs.

Other Contributing Factors: Inventory and Exports

The data indicates that the second-quarter weakness can also be attributed to reduced inventory accumulation and a slower pace of growth in exports. Canada's exports of goods and services only increased by 0.1% in Q2, compared to a more substantial 2.5% increase in the first quarter.

Stability in July's GDP and the Rise in Inflation

Preliminary estimates suggest that the GDP for July remained relatively stable. In August, the country's inflation rate ticked higher as mortgage costs continued to rise for the fifth consecutive month, marking the most significant increase on record.

Anticipation for the Bank of Canada's Decision

Many Canadians are eagerly awaiting the Bank of Canada's (BoC) upcoming interest rate decision next week, especially after the BoC raised its key interest rate target by a quarter of a percentage point to 5% in July.

Impact of Higher Interest Rates and RBC's Insights

These latest statistics reveal that the effects of higher interest rates are beginning to have an impact, resulting in a cooling economy with reduced consumer spending – precisely the intended outcome of monetary policy. In response to the latest economic data released this morning, RBC Economics, in their Daily Economic Update, has indicated that these numbers are likely to strengthen the prevailing expectations that the Bank of Canada (BoC) will abstain from implementing another interest rate hike.

Analyzing RBC Economics' Perspective

The commentary in the update notes that the minor decline in the second quarter is not entirely unexpected, as previous early estimates of GDP have exhibited a tendency to be revised. Furthermore, there have been indications suggesting that the obstacles to economic growth resulting from elevated interest rates have been quietly accumulating beneath the surface.

The Path Forward for Interest Rates

RBC recognizes that the central bank is unlikely to overly emphasize a single data point and acknowledges that inflation remains persistently above the targeted levels. Nonetheless, a cooling economy may provide some relief for borrowers. The update contends that there is accumulating evidence that the delayed consequences of earlier interest rate hikes are starting to exert a more pronounced impact in moderating both GDP growth and labor markets. Consequently, this should lead to a gradual slowdown in inflationary pressures. The update further posits that policymakers will want to maintain the option of resuming rate hikes if necessary. However, if the unemployment rate continues to rise, as anticipated, a resumption of rate hikes may not be required.

On Wednesday, the Bank of Canada raised its overnight rate by 25 basis points, bringing it to 5.0 percent. This decision is part of a significant tightening of monetary policy, returning interest rates to levels not seen since the 2007-08 financial crisis. For some, this latest rate hike feels like the decisive blow that solidifies a troubling situation, while others hope it truly marks the end of rate increases. Tiff Macklem, the governor of the Bank of Canada, expresses uncertainty and asserts that further rate hikes are not off the table if deemed necessary.

The recent unexpected rate hike appears to have had an immediate impact on the sentiment of the real estate market. It could be seen as another minor warning sign, similar to the initial 25 basis point hike in February 2022, as it has achieved a comparable outcome. There are reports of distress among homeowners circulating within the real estate community, with many professionals publicly expressing empathy towards those facing difficulties.

As a result of the rate hike, commercial bank prime rates have risen to 7.20 percent. Consequently, variable rate mortgages are now hovering around the 6.0 percent range, while HELOCs (Home Equity Lines of Credit) are surpassing 7.50 percent for most borrowers. This represents a significant increase from the rates of approximately 3.0 percent that instilled great confidence in the market during the peak of the pandemic era.

Following the announcement of the rate hike, the Canada 5-Year Government Bond yield experienced a consistent decline throughout the day on July 12. It started at 3.950 percent at the opening and closed at 3.812 percent. The yields have remained relatively stable within this range, which holds crucial importance as it serves as the primary pricing gauge for fixed-rate mortgages.

In Canada, fixed-rate mortgages are closely linked to government bond yields, specifically the yields of Government of Canada bonds with similar maturity periods. As bond yields rise, lenders are compelled to raise mortgage rates to make them more attractive investments compared to those bonds. If not, banks would prefer investing their funds in bonds, which are regarded as one of the safest investment options. Typically, banks add a risk premium to mortgage products, resulting in pricing at "GOC+2" or the bond yield plus 2.0 percent. Based on the current yields, this would translate to mortgage rates in the range of high 5.0 percent to low 6.0 percent.

Conversely, when bond yields decline, fixed mortgage rates tend to follow suit, making them more affordable for borrowers. Therefore, fluctuations in Canadian bond yields play a significant role in influencing the direction of fixed mortgage rates in the country.

This is the primary challenge faced by the Bank of Canada. Currently, a majority of homebuyers opt for fixed-rate mortgages due to their more favorable pricing compared to variable-rate mortgages. Consequently, when the central bank raises the interest rate, it does not significantly affect the demand side of the equation. Instead, it exerts pressure on the supply side, leading to financial strain and creating an incentive for property owners to sell. From the sounds of it, this is precisely the outcome they have achieved, as an increasing number of sellers are conceding to the Bank of Canada's influence. As a result, new property listings are generally surpassing sales, a trend that hasn't been observed for some time.

The Bank of Canada's focus on the housing market became evident through its Quarterly Monetary Policy report. Additionally, during the subsequent press release, Governor Macklem indicated a shift in reliance from unemployment as a key performance indicator (KPI) to placing increasing importance on the housing market and immigration in establishing potential outcomes for the Canadian economy.

In the release, Macklem acknowledged the significant impact of the interest rate hikes on the housing market, leading to a notable slowdown. However, he also noted that the slowdown was not as substantial as initially anticipated, and housing activity has since rebounded.

Macklem referred to the previous year's significant decline in house prices, which began following the initial rate hike in February. This decline resulted in a nearly 20 percent year-over-year drop in house prices, surpassing the previous record "crash" in house prices experienced by Canada in 1989.

Now we come to the significant questions: Is the ordeal reaching its conclusion? When will things start improving?

Initially, Macklem hinted that 5.0 percent might be the limit or the point at which he would cease increasing the overnight rate. We must remember that the Bank of Canada (BoC) has a mandated target rate of 2% to achieve. Finally, the overnight rate has significantly exceeded the inflation rate. This indicates that, when adjusted for inflation, the real interest rate has become positive.

The real interest rate is calculated as the nominal interest rate minus the inflation rate.

Traditionally, the nominal interest rate needs to align with the inflation rate before a reversion begins. On average, interest rates tend to remain at their peak for around nine months before rate cuts are implemented.

The Bank of Canada (BoC) caused a surprise in financial markets by increasing its policy rate by an additional 0.25% during the previous week. As a result, Canadian homeowners who possess variable-rate mortgages and/or home-equity lines-of-credit will experience a corresponding rise in their interest rates in the near future.

Bond-market investors had anticipated an increase in the Bank of Canada's policy rate at its upcoming meeting scheduled for July. However, the Bank chose not to wait until then and surprised the market.

In its policy statement, the Bank concluded that "monetary policy was not sufficiently restrictive." The following day, BoC Deputy Governor Paul Beaudry justified the decision by explaining that "excess demand in the Canadian economy is more persistent than we thought, and it increases the risk of the decline of inflation could stall."

Although the Bank had always kept the option open for further rate hikes if deemed necessary, the timing of their recent action and the rationale behind it left many market observers bewildered.

In January, the BoC said that it would take “an accumulation of evidence” to move it off the sidelines. In the end, it moved after only two policy-rate meetings.

The Bank is focusing on four key elements: 1) the evolution of excess demand, 2) inflation expectations, 3) wage growth and 4) corporate pricing behaviour.

1) EXCESS DEMAND - The Bank of Canada (BoC) noted that demand was unexpectedly robust and widespread. However, it did not explicitly acknowledge that a substantial portion of this additional demand can be attributed to the rapid depletion of savings accumulated during the pandemic. This temporary surge in demand is projected to diminish later this year, well before the effects of last week's rate hike become significant. It's important to note that rate hikes typically take effect with a delay and have an impact that lasts for approximately two years.

2) INFLATION EXPECTATION- The inflation expectations of both consumers and businesses continue to remain high, and this sentiment was not alleviated by the announcement that our Consumer Price Index (CPI) increased from 4.3% in March to 4.4% in April. It is possible that the Bank possesses information that is not yet available to the public. Although the most recent consumer and business expectation surveys are set to be released in July, Stephen Brown, Deputy Chief Economist at Capital Economics, confirmed that the Bank already has access to those findings (more details on this matter will be provided later in this post).

3) WAGE GROWTH - The overall nominal wage growth continues to maintain a pace of approximately 5% on an annualized basis. However, the Bank of Canada (BoC) has cautioned that unless there is a significant increase in productivity (which has been declining steadily), inflation will persist above the target level. On the other hand, real wage growth, which considers inflation's impact on nominal wage growth, remains below 1% and is still lower than pre-pandemic levels. Consequently, the average worker's purchasing power is barely improving. In other words, wage growth is unable to generate substantial excess demand. Additionally, there are indications that employment momentum is slowing. Job vacancies have been steadily decreasing over the past two quarters, labor force growth is surpassing the rate of hiring, and most recently, it was revealed that an estimated 17,200 jobs were lost in May. These factors collectively suggest an impending deceleration in wage growth.

4) CORPORATE PRICING BEHAVIOUR - Businesses tend to set prices based on market conditions, but it is primarily the limited savings buffer mentioned earlier that has enabled consumers to withstand higher prices without reducing their spending. However, this buffer is diminishing rapidly. As demand declines, profit margins will shrink rapidly, as there is less consumer spending to go around.

If the Bank of Canada (BoC) is expected to anticipate future trends when setting its monetary policy, why is it relying on indicators that reflect past conditions to justify another round of tightening, which will only have a significant impact a year or two from now?

I believe the decision to raise interest rates is driven by two crucial and interrelated objectives: 1) to manage inflation expectations and 2) to slow down the upward momentum of real estate prices.

Although inflation only rose slightly from 4.3% in March to 4.4% in April, it marked the first month-over-month increase since inflation reached its peak in June 2022. Many people may not delve deeper into the news beyond the headlines announcing the resurgence of inflation.

Implementing another rate hike attracts attention and helps to anchor inflation expectations.

More significantly in the current context, last week's rate hike will also dampen the momentum of our recently revived real estate markets. The Bank likely wanted to take action without further delay.

Real estate was expected to cool down for a period after the Bank of Canada implemented its most substantial series of rate hikes in modern history. However, the Bank's decision to pause in January unexpectedly fueled the market. When buyers learned that interest rates would no longer increase, they reentered the market, leading to excessive demand for limited housing supply.

Subsequently, the US banking crisis triggered a significant drop in bond yields, which in turn caused fixed mortgage rates to decline by 0.50% or more. Bidding wars resurfaced, and prices began to rise once again.

In its policy statement, the Bank of Canada acknowledged that "buyers were returning to the housing market, despite tight supply," and noted the "unexpected" strength in goods spending, particularly the demand for interest-rate-sensitive goods such as furniture and appliances, which are closely linked to home purchases.

The strong rebound in the real estate market significantly influences consumer inflation expectations, according to economist Stephen Brown, who recently highlighted the Bank's research indicating a strong correlation between house prices and consumer inflation expectations.

While the Bank's most recent rate hike did lead to a 0.25% increase in variable mortgage rates, the greatest impact was seen in fixed rates, which is the preferred choice for most borrowers nowadays. In a short span, three-, four-, and five-year fixed rates have surged by 0.50% or more, approaching their previous cycle peaks. Currently, this aligns with the Bank of Canada's intentions.

The favorable conditions resulting from the US banking crisis have now completely dissipated, with any expectations of rate cuts forgotten. Prospective homebuyers are once again concerned about the potential increase in near-term mortgage rates.

From the perspective of the Bank of Canada, their mission is accomplished for now.

So, what should you do if you are in the market for a mortgage today?

When the US banking crisis led to a decline in our bond yields, it created advantages for new borrowers opting for fixed rates, but it came at the expense of existing variable-rate borrowers. Lower fixed rates undermined the Bank's efforts to slow demand and consequently delayed the implementation of variable-rate cuts.

Fixed rates have become increasingly favorable for several reasons.

These rates are based on bond yields that had previously factored in the expectation of policy rate cuts by the Bank of Canada (BoC) and the Federal Reserve in the upcoming fall, despite BoC Governor Macklem publicly dismissing such a notion. Those who secured a fixed rate during a period when the bond market anticipated near-term rate cuts are currently benefiting from their decision.

Present-day fixed mortgage rates now reflect a viewpoint of prolonged higher rates. Currently, the bond market has aligned with the BoC's perspective.

Interestingly, each rate hike by the BoC increases the risk of excessive tightening. This raises the likelihood that, when economic slowdown accumulates and prompts a reversal in policy, the Bank may need to implement rate cuts sooner and more aggressively than it otherwise would have. Although this argument holds theoretical validity, it may be challenging for borrowers to let it significantly impact their decision-making, especially considering that variable rates are even higher now and the bond market believes additional rate hikes are not just possible but likely.

For the time being, I maintain the belief that the safest choice for individuals currently seeking a mortgage and aiming for a balanced approach is a three-year fixed rate.

Those who opt for this choice must accept the risk of potentially paying an above-market rate in the later part of their term. However, most borrowers view this as a trade-off worth making when the alternatives are longer terms (which amplify the risk) or variable rates and shorter-term fixed rates (which appear to be consistently rising).

The main point is that the increase in Government of Canada (GoC) bond yields led to lenders raising their fixed mortgage rates once again.

The recent surge in GoC bond yields suggests an expectation that the Bank of Canada (BoC) will likely increase its policy rates before the end of the year. Consequently, there may be a possibility of a near-term pullback following such a significant movement. This could result in fixed mortgage rates remaining stable at their new elevated levels for the foreseeable future.

Variable-rate discounts remained unchanged last week. However, the unexpected 0.25% hike by the BoC last Wednesday means that borrowers with variable rates will soon experience a corresponding increase in their borrowing costs.