Coming soon: higher interest rates

This may be the best example of why the rates are going to start to go back to their long term average of 6. 5% for the 5 year. Now may be the best time to look at locking-in if you are in the variable rate.
It is also a great time to:
  • refinance – or re-do your mortgage – and get today’s rates for another 5 years,
  • roll in some higher interest payments – like LOC -Line of Credit or credit cards or,
  • buy your first home before rates go up or,
  • finally get that summer/ ski vacation cabin.

Call for a free 5-minute mortgage check-up while there is still time. (That may be 2 or 3 weeks from now as the bond market will smell this coming inflation pretty quickly.)

Linda Nazareth, Senior Economic Analyst, BNN
Higher Canadian rates, sooner. That’s what the markets figured out this week and that’s what is powering the Canadian dollar. Sometimes when you see a big market reaction you know it’s probably an over-reaction and you can ignore it – but not this time.

Let’s start with a little tutorial (no, please keep reading, it will be brief) and then we’ll talk about why this week’s economic data changes everything, more or less.

The Bank of Canada sets the benchmark overnight rate (the rate at which banks lend to each other). That in turn affects market interest rates on everything from mortgages through to business loans. At present, the overnight rate is at 1 percent, following three hikes of 25 basis points each last year.

The tutorial is on the ‘output gap’ which is one of the major tools that the Bank of Canada looks at to set monetary policy. Here goes.

The ‘output gap’ refers to the difference between the actual output of the economy and the potential output. Potential output basically refers to the maximum that could be produced if all inputs (like the labour force, technology, capital, factory space and all that) were used to the fullest extent that they can be without triggering inflation.  That last little bit is key: when the bank says ‘potential’ they don’t mean full potential, they mean ‘potential without forcing prices higher’. It is a similar concept to what economists mean when they say ‘full employment’. In that case it does not mean everyone working, it means everyone working that can be working without wages being forced higher.

The Bank of Canada monitors the output gap as best they can, first by estimating what potential output is in any period of time, then estimating how close to potential the economy looks to be. A positive output gap means the economy is operating above potential, and that inflation is a risk. A negative gap means there is excess supply (for example, too many unemployed workers) and that inflation is not a risk, or at the extreme, that deflation is possible.

The Bank of Canada adjusts policy to try to get keep things in balance and the output gap closed – sort of a ‘not too hot, not too cold’ thing. Based on their most recent calculations, their latest estimate (which was contained in last week’s Monetary Policy Review) was that the output gap would close by the middle of 2012.

Everybody still with me? Good. Here’s the thing: as well as looking at the output gap itself, the Bank also looks at a bunch of economic indicators to see how close to capacity the Canadian economy is running. Things like industrial production, the unemployment rate, unfilled manufacturing orders – and inflation.

That last one is probably the most important, and it is the one that seems to be running most out of sync with where the Bank of Canada thought it would be. In the Monetary Policy Report, the Bank said that the overall inflation rate (which they target to be 1 to 3 percent) would peak at 3 percent in the second quarter. This week, we got the March inflation report, and we find out that the inflation rate was 3.3 percent as of March –  which is decisively in the first quarter. Ouch.

So what does this mean? It means something has to change to keep the Canadian economy from overheating. That something is likely to be Canadian interest rates, and when I say ‘change’ I mean ‘go higher’.

If rates do not go higher, then the output gap is at risk of going into positive territory, which means inflation takes off even more. No way is the Bank of Canada going to let that happen.

There are other things to take into account too – the spiky Canadian dollar is an important one – but it does not take away from the big picture.

Big picture? A rate hike by July, and maybe more to come after that. And yes, watch the loonie soar in the meantime.

locking in …

Is It Time to Lock In?

With people banking on the main interest rate going up in June, it seems like a good time to for homeowners to lock in their fixed-rate mortgages.

About 12 percent of mortgage holders with fixed-rate mortgages “locked in,” or switched from variable rate mortgages, in the past year, , according to a report this month by Will Dunning, chief economist at the CAAMP , and another 10 percent had already switched from variable more than a year ago.

The rate for conventional five-year mortgages was at 6.25 per cent at the end of April, nearing the 5.25 per cent rate at the end of May last year – the lowest since 1973 when the Bank of Canada data began.

“As interest rates rise, expect home buyers to increasingly opt for fixed-rate loans, in turn leaving banks with more fixed-rate assets to hedge in the swap market” said Mohammed Ahmed, a rates strategist at Canadian Imperial Bank of Commerce in Toronto.

My View:

What is all the panic to lock mortgages into fixed rates? Sure interest rates will start rising, they have no where else to go, but I have not heard anyone saying that these rate hikes will be aggresive and fast. Being in a variable of 1.70% today is way better than being locked into a 5 year fixed of 4.4%. That’s a difference of 2.7%!!! It will take 10 rate increases or so for the variable to just reach the same level. The question is how many years will it take for rates to increase 10 times?