Mortgage Rate Outlook

LOWER, BUT FOR HOW MUCH LONGER?

• Mortgage rates remain at historic lows

• Canadian economy roars back in second quarter

• Poor job growth keeps Bank of Canada in neutral

 In stark contrast to the consensus of economists’ expectations at the end of last year, bond yields

have spent most of 2014 trending downward. Indeed, perhaps weary of previous false starts, bond markets have even shrugged off recent signs of a strengthening economy, an acceleration of inflation and the unwinding of stimulus from the US Federal Reserve. Lenders have responded in kind, offering homebuyers record low mortgage rates. 

Given well anchored inflation expectations and near consensus that short-term rates will be higher

next year, the continued downtrend in bond yields this year is difficult to explain. One factor could

be that investors are acclimating to the idea that the neutral rate, or the Bank of Canada’s preferred

destination for interest rates once it tightens, is likely much lower than in the past and that realization is being priced into expectations and therefore long-term interest rates.

Additionally, the performance of Canada’s financial and banking system post-financial crisis has won

it a reputation among foreign investors as a safe harbor. Foreign holdings of Canadian government

bonds and treasury bills have jumped from 15 per cent to over a quarter of outstanding debt since the global financial crisis. As uncertainty mounts in other areas of the world due to weak economic growth or unresolved conflicts, assets have crowded into both US and Canadian debt securities, forcing yields lower. Given these factors, rates could remain below historical average levels even as the Bank of Canada begins tightening.

While we do not expect the Bank to act on interest rates until late in 2015, bond yields could rise

modestly before then in anticipation of higher rates, particularly if economic growth is stronger

than expected. If so, we expect to see a slight increase in five-year and one-year fixed mortgage

rates by the end of 2014.

Economic Outlook

As was widely expected, the Canadian economy’s weak start to the year proved to be temporary as

growth roared back in the second quarter. Canadian real GDP expanded 3.1 per cent at an annual rate

last quarter, the highest rate of growth in close to three years. That growth was largely spurred by

exports to a similarly resurgent US economy, which grew at a robust 4.2 per cent annual rate in the

second quarter. If momentum in the US economy can be sustained, the long awaited rotation of

Canadian economic growth towards exports and business investment could be realized. Indeed,

in past business cycles, a recovery in business investment tends to lag behind a recovery in export

growth.

While we expect that economic growth will slow moderately from the robust pace of the second quarter, it will remain relatively strong at 2.3 per cent for 2014 before accelerating next year to 2.7 per cent.

CPI inflation, which has been above the Bank’s 2 per cent target for several months, is showing some signs of softening due to a sharp decline in the price of energy products and other commodities. Core inflation, which the Bank uses as its operational guide for monetary policy, has drifted higher but remains relatively muted. Though some wage inflation has occurred of late, slack in the labour market and continued competitive pressure in retail sectors will likely keep core inflation from breaching the Bank’s 2 per cent target in the short-term.

Interest Rate Outlook

While economic growth exceeded expectations in the second quarter, the economy looks far more

pedestrian if averaged over the entire first half of 2014. Employment growth has been uneven and the

Canadian unemployment rate remains stubbornly high. Given a weak labour market, the Bank of

Canada is unlikely to be moved from its current stance after just one strong quarter of economic

growth. We expect that the Bank will continue to take a cautious approach to monetary policy until

it sees concrete signs that the economy is growing sustainably above trend.

Our modelling exercises show the Canadian output gap closing along the same timeline as expected

by the Bank of Canada, with inflation returning to target in 2016. Therefore, while the Bank left the

door open to lower interest rates given its “neutral” stance, lags in monetary policy suggest a tightening of interest rates in the second half of 2015.

“Copyright British Columbia Real Estate Association. Reprinted with permission.”