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Bank of Canada increases the overnight rate to 1.0%. Should I convert my variable?

 Sep 6, 2017 5:00 PM

The Bank of Canada released their statement today on their scheduled Rate Announcement. To those that are hawkish (a bias towards an increasing rate) they didn’t disappoint. They increased their overnight rate back to 1.0% from 0.75%. In a sense, they’ve removed the two “emergency cuts” did back in 2015 when oil prices were sliding. At that time, these cuts were a big surprise to everyone because it was already unprecedented that the overnight rate was a measly 1.0%.

Gordon Gekko: Greed is Good

Starting today, it’s expected that all Banks and Financial Institutions will increase their Prime Rates by the same 0.25%. The last time the Bank of Canada increased the overnight rate it was on July 12th. It’s interesting that back in 2015 the overnight rate was 1.00% and Prime was 3.00%. Now, it’s going to be 1.00% again and the Prime is 3.20%. The reason for the difference is because when the overnight rate dropped by 0.25%, the Banks only decreased their Prime rate by only 0.15% each time but when the overnight increased they pass through the entire 0.25%. It’s called funny math and it results in Bank’s generating over a billion dollars in quarterly profit.

Increasing RatesReasons for the Overnight Rate Increase

The Bank of Canada sees a bunch of stimulus in our economy and they want to slow it down. Govonor Poloz has used the analogy applying the breaks slowly to a speeding car instead of having to slam on the breaks suddenly. It’s fair to say the economy, right now, has been moving at a blistering pace. Last week the GDP numbers showed the economy growing at an annualized pace of 4.5%. Most economists were expecting a GDP rate of about 3.7% so this surprised many people. The US for comparison is showing a 3.0% increase.

The Bank of Canada uses this lever (raising rates) in their arsenal primarily to control inflation. When inflation needs to be lowered they raise rates. Even though inflation is still super low, below their target bands, it’s expected that inflation will eventually increase as the economy moves along… hence, applying a little bit of the breaks. Personally, I like to think of it as they are removing the temporary rate cuts from 2015.

From a housing perspective, the GTA/VTA housing bubbles haven’t popped suddenly. Phew! It’s been more like a deflating of the balloon and we should see housing prices stabilize. It seems likely that the housing market and debt holder can absorb another quarter point increase.

Will Rates Rise Again?

It’s tough to say but I’m of the opinion that rates will be parked at 1.0% for a little bit to see what happens. There are too many pressures right now on the economy to warrant much more of increase. The dollar has risen quite dramatically to 82 cents USD. This recent increase puts more pressure on our manufacturing sector and exports are now more expensive. This alone should help cool things a bit.

Furthermore, there have been so many forces in play to slow down the housing market that another increase in rates could push it over the ledge! There have been insurance rule changes, insurance cost increases, regulator rule changes, department of Finance rule changes, etc. More specifically they said, “Given elevated household indebtedness, close attention will be paid to the sensitivity of the economy to higher interest rates”.

Pushing the housing market into a steep decline can have deeper consequences. The evaporation of household wealth is one. Another is that this household debt market has fueled the growth of the economy more than business growth. Pushing it too hard could put the economy into a tailspin and reset the gains made. I might be wrong but I think that any major economic calamity has be precipitated by a big housing drop.

Should I convert my Variable Rate mortgage to Fixed Rate?

The answer depends on your personal situation. It depends on how many years you have remaining, what rate you have, what rate you are being offered, how likely you are to move or refinance, etc. All of this matters because it impacts things such as penalty calculations and how much interest you’re likely to pay over the next few years. This is the total cost.

If you do convert, keep in mind you are converting at the fixed rates offered today, not what they were when you first got your mortgage. For the vast majority of people, the economics don’t make sense to convert. However, the best thing to do is call a professional who can help you figure it out. I’ve developed models in Excel that determine the cost-benefit of making a switch and assign probabilities to certain scenarios. For example, a scenario of a decreasing prime rate is very unlikely and would receive a low probability.

Key Point

Govenor Poloz and the Bank of Canada are seeing our wonderful economic reports and slowing things down ahead of any inflation report suggesting otherwise. Whether or not it represents a patterned increase in rates depends on what goes on with our economy and in the U.S. I personally believe we’ll be flat for another 6 months as they wait and see what happens. Their next rate announcement and monetary policy report is on October 26th this year.

For variable rate customers, the decision to convert to fixed isn’t clear and it depends on the inputs and assumptions.

 

About the Author:

Ian Mucignat, CFA, is an independent mortgage agent at TMG The Mortgage Group. He graduated from Wilfrid Laurier University with a Bachelor of Business Administration, minoring in Economics and is a CFA Charterholder. Ian has worked in the mortgage industry since 2000 at lenders, banks, and brokerages. If you are purchasing, renewing, or refinancing your mortgage don’t hesitate to contact Ian directly for a free consultation.

Interest Rate, Economy  


  


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