Cheaper Mortgages?

Happy Monday Morning!

I just got back from presenting at the annual Veritas Real Estate conference in Toronto. The conference, which caters towards investment professionals and financial institutions engaged in a healthy debate on the direction of our housing market. There was a lengthy discussion on interest rates, which is undoubtedly one of, if not the largest influences on house prices.

Yes, rates are falling, that much we know. The Bank of Canada is going to continue to lower rates because the economy is weak, unemployment is rising, and inflation is in the rearview mirror, at least for now. But will this actually be bullish for housing in the near term?

Everything we are seeing so far suggests that lower rates are actually spurring more sellers than buyers! When rates were rising sellers figured it was a bad time to list and actually witheld inventory from the market. New listings collapsed to 20 year lows at one point last year. Now that rates are falling it’s time to sell, after all, lower rates are bullish!

Greater Vancouver new listings in September were the second highest on record, just behind September 2020 when 18% of all mortgages were being deferred. We now have 8 months of inventory for sale.

Source: Steve Saretsky

The only other difference between today and September 2020, was that home sales were 50% lower this time around!

In other words, listings have ramped up but demand has not budged. Que the BoC! We need more cuts!

The Bank of Canada is projected to slash the overnight rate by another 200bps by later next year. Lower mortgage rates for all! Not so fast.

The Bank of Canada only controls variable rate mortgages. If they cut by the expected 200bps it will bring most variable rate mortgages into the mid to high 3’s, only slightly lower than where fixed rates are today. In other words, fixed rates have mostly priced in the aggressive rate cutting cycle from the BoC.

As noted in a recent research piece from Desjardins,

Anyone hoping for a dramatic drop in retail rates may be disappointed. Based on our observations, 5‑year fixed mortgage rates have already fallen more than  170 basis points compared to their recent peak. In fact, they could even start edging back up in 2025 as the outlook for the Canadian economy improves. Variable rates will come down in proportion to policy rate cuts. But given their significantly higher starting point, variable rates probably won't end more than 50 points lower than the current 5‑year fixed rate even when the policy rate reaches its anticipated low of 2.25% (graph 3). The reason is simple: since the BoC's policy rate cuts have been widely anticipated, the reductions have already been priced into fixed mortgage rates. 

Source: Desjardins

This matters because every buyer and seller we chat with today keeps talking about lower rates as if they are going to move lower for all variable and fixed rate products. But how many are paying attention to the yield curve? I can assure you the average home buyer and seller does not know what the yield curve is nor do they care, but they should.

If history is any guide, assuming the Bank of Canada does indeed cut rates to 2.25%, then the 5 year bond yield should be about 50-75bps higher, or in other words right around 3% which is exactly where we are today.

Source: Ice Cap Asset Management

The 5 year bond yield sits comfortably at 3% today. Again, lower rates appear mostly priced in for fixed rates. This begs the question, maybe, just maybe, the current 5 year fixed rate mortgage is as good as it gets. Low 4’s.

Yes rates could move lower assuming the global economy hits a wall and slides into a recession, but you could also make an argument for higher yields. After all, the economic data in the US is not that bad, and geopoltical tensions are rising in the middle east pushing energy prices higher. Just this past week we had US non farm payrolls come in hotter than expected and oil prices up nearly 10% on a rope. Yields have pushed higher since, the Canada 5 year bond yield is up 30bps over the past week.

Source: CNBC

Look I’m no bond trader and i’m certainly not qualified to make economic forecasts. What i’m suggesting is too many Canadians are assuming lower mortgage rates are a given just because the Bank of Canada is expected to keep cutting rates.

If we want to see lower fixed rate mortgages, history suggests the BoC will need to cut rates even more than already anticipated.

It’s worth asking what type of economic environment we’ll be situated in if the BoC needs to cut rates by more than 200bps from here?

Maybe we should just accept that 4 is the new 2. Would a 4% mortgage rate be that bad? That’s still historically cheap money.

What does the bond market know?