WHY ARE MORTGAGE RATES RISING?

General Michelle Foster 31 Mar

Why Are Mortgage Rates Rising?

Over the past month, the Bank of Canada has lowered its overnight rate by a whopping 1.5 percentage points to a mere 0.25%. Many people expected mortgage rates to fall equivalently. The banks have reduced prime rates by the full 150 basis points (bps). But, since the second Bank of Canada rate cut on March 13, banks and other lenders have hiked mortgage rates for fixed- and variable-rate loans. That’s not what happens typically when the Bank cuts its overnight rate. But these are extraordinary times.

The Covid-19 pandemic has disrupted everything, shutting down the entire global economy and damaging business and consumer confidence. No one knows when it will end. This degree of uncertainty and the risk to our health is profoundly unnerving.

Most businesses have ground to a halt, so unemployment has surged. Hourly workers and many of the self-employed have found themselves with no income for an indeterminate period. All but essential workers are staying at home, including vast numbers of students and pre-school children. Nothing like this has happened in the past century. The societal and emotional toll is enormous, and governments at all levels are introducing income support programs for individuals and businesses, but so far, no cheques are in the mail.

In consequence, the economy hasn’t just slowed; it has frozen in place and is rapidly contracting. Travel has stopped. Trade and transport have stopped. Manufacturing and commerce have stopped. And this is happening all over the world.

What’s more, the Saudis and Russians took advantage of the disruption to escalate oil production and drive down prices in a thinly veiled attempt to drive marginal producers in the US and Canada out of business. This has compounded the negative impact on our economy and dramatically intensified the plunge in our stock market.

Many Canadians are now forced to live off their savings or go into debt until employment insurance and other government assistance kicks in, and even when it does, it will not cover 100% of the income loss. The majority of the population has very little savings, so people are resort to drawing on their home equity lines of credit (HELOCs), other credit lines or adding to credit card debt. Businesses are doing the same.

The good news is that people and businesses that already have loans tied to the prime rate are enjoying a significant reduction in their monthly payments. All of the major banks have reduced their prime rates from 3.95% to 2.45%. So people or businesses with floating-rate loans, be they mortgages or HELOCs or commercial lines of credit, have seen their monthly borrowing costs fall by 1.5 percentage points. That helps to reduce the burden of dipping into this source of funds to replace income.

So Why Are Mortgage Rates For New Loans Rising?

These disruptive forces of Covid-19 have markedly reduced the earnings of banks and other lenders and dramatically increased their risk. That is why the stock prices of banks and other publically-traded lenders have fallen very sharply, causing their dividend yields to rise to levels well above government bond yields. As an example, Royal Bank’s stock price has fallen 22% year-to-date (ytd), increasing its annual dividend yield to 5.31%. For CIBC, it has been even worse. Its stock price has fallen 30%, driving its dividend yield to 7.66%. To put this into perspective, the 10-year Government of Canada bond yield is only 0.64%. The gap is a reflection of the investor perception of the risk confronting Canadian banks.

Thus, the cost of funds for banks and other lenders has risen sharply despite the cut in the Bank of Canada’s overnight rate. The cheapest source of funding is short-term deposits–especially savings and chequing accounts. Still, unemployed consumers and shut-down businesses are withdrawing these deposits to pay the rent and put food on the table.

Longer-term deposits called GICs, which stands for Guaranteed Investment Certificates, are a more expensive source of funds. Still, owing to their hefty penalties for early withdrawal, they become a more reliable funding source at a time like this. As noted by Rob Carrick, consumer finance reporter for the Globe and Mail, “GIC rates should be in the toilet right now because that’s what rates broadly do in times of economic stress. But GIC rates follow a similar path to mortgage rates, which have risen lately as lenders price rising default risk into borrowing costs.”

To attract funds, some of the smaller banks have increased their savings and GIC rates. For example, EQ Bank is paying 2.45% on its High-Interest Savings Account and 2.55% on its 5-year GIC. Other small banks are also hiking GIC rates, raising their cost of funds. Rob McLister noted that “The likes of Home Capital, Equitable Bank and Canadian Western Bank have lifted their 1-year GIC rates over 65 bps in the last few weeks, according to data from noted housing analyst Ben Rabidoux.”

The banks are having to set aside funds to cover rising loan loss reserves, which exacerbates their earnings decline. An unusually large component of Canadian bank loan losses is coming from the oil sector. Still, default risk is rising sharply for almost every business, small and large–think airlines, shipping companies, manufacturers, auto dealers, department stores, etc.

Lenders have also been swamped by thousands of applications to defer mortgage payments.

Hence, confronted with rising costs and falling revenues, the banks are tightening their belts. They slashed their prime rates but eliminated the discounts to prime for new variable-rate mortgage loans. Some lenders will no doubt start charging prime plus a premium for such mortgage loans. Banks have also raised fixed-rate mortgage rates as these myriad pressures reducing bank earnings are causing investors to insist banks pay more for the funds they need to remain liquid.

An additional concern is that financial markets have become less and less liquid–sellers cannot find buyers at reasonable prices. The ‘bid-ask’ spreads are widening. That’s why the central bank and CMHC are buying mortgage-backed securities in enormous volumes. That is also why the Bank of Canada has started large-scale weekly buying of government securities and commercial paper. These government entities have become the buyer of last resort, providing liquidity to the mortgage and bond markets.

These markets are crucial to the financial stability of Canada. Large-scale purchases of securities are called “quantitative easing” and have never been used before by the Bank of Canada. It was used extensively by the Fed and other central banks during the 2008-10 financial crisis. When business and consumer confidence is so low that nothing the central bank can do will spur investment and spending, they resort to quantitative easing to keep financial markets functioning. In today’s world, businesses and consumers are locked down, and no one knows when it will end. With so much uncertainty, confidence about the future diminishes. The natural tendency is for people to cancel major expenditures and hunker down.

We are living through an unprecedented period. When the health emergency has passed, we will celebrate a return to a new normal. In the meantime, seemingly odd things will continue to happen in financial markets.

Dr. Sherry Cooper

DR. SHERRY COOPER

Chief Economist, Dominion Lending Centres
Sherry is an award-winning authority on finance and economics with over 30 years of bringing economic insights and clarity to Canadians.

BANK OF CANADA CUTS RATES 50 BPS TO 0.25%

General Michelle Foster 27 Mar

 

Bank of Canada Moves to Restore “Financial Market Functionality”

The Bank of Canada today lowered its target for the overnight rate by 50 basis points to ¼ percent. This unscheduled rate decision brings the policy rate to its effective lower bound and is intended to provide support to the Canadian financial system and the economy during the COVID-19 pandemic (see chart below).

Strains in the commercial paper and government securities markets triggered today’s action to engage in quantitative easing. The Governing Council has been meeting every day during the pandemic crisis. Market illiquidity is a significant problem and one the Bank considers foundational. These large-scale purchases of financial assets are intended to improve the functioning of financial markets.

Credit risk spreads have widened sharply in recent days. People are moving to cash. Liquidity has dried up in all financial markets, even government-guaranteed markets such as Canadian Mortgage-Backed securities (CMBs) and GoC bills and bonds. The commercial paper market–used by businesses for short-term financing–has become nonfunctional. The Bank is making large-scale purchases of financial assets in illiquid markets to improve market functioning across the yield curve. They are not attempting to change the shape of the curve for now but might do so in the future.

These large-scale purchases will create the liquidity that the financial system is demanding so that financial intermediation can function. Risk has risen, which creates the need for more significant cash injections.

At the press conference today, Senior Deputy Governor Wilkins refrained from speculating what other measures the Bank might take in the future. When asked, “Where is the bottom?” She responded, “That depends on the resolution of the Covid-19 health issues.”

The Bank will discuss the economic outlook in its Monetary Policy Report at their regularly scheduled meeting on April 15. In response to questions, Governor Poloz said it is challenging to assess what the impact of the shutdown of the economy will be. A negative cycle of pessimism is clearly in place. The Bank’s rate cuts help to reduce monthly payments on floating rate debt. He is hoping to maintain consumer confidence and expectations of a return to normalcy.

The oil price cut alone would have been sufficient reason for the Bank of Canada to lower interest rates. The Covid-19 medical emergency and the shutdown dramatically exacerbates the situation. All that monetary policy can do is to cushion the blow and avoid structural problems to the economy. The overnight rate of 0.25% is consistent with market rates along the yield curve.

High household debt levels have historically been a concern. Monetary policy easing helps to bridge the gap until the health concerns are resolved. The housing market, according to Wilkins, is no longer a concern for excessive borrowing by cash-strapped households.

At this point, the Bank is not contemplating negative interest rates. Monetary policy has little further room to maneuver, given interest rates are already very low. With businesses closed, lower interest rates do not encourage consumers to go out and spend money.

Large-scale debt purchases by the Bank will continue for an extended period to provide liquidity. The Bank can do this in virtually unlimited quantities as needed. The policymakers are also focussing on the period after the crisis. They want the economy to have an excellent foundation for growth when the economy resumes its normal functioning.

Fiscal stimulus is crucial at this time. The newly introduced income support for people who are not covered by the Employment Insurance system is a particularly important safety net for the economy. There are many other elements of the fiscal stimulus, and the government stands ready to do more as needed.

The Canadian dollar has moved down on the Bank’s latest emergency action. The loonie has also been battered by the dramatic decline in oil prices. Canada is getting a double whammy from the pandemic and the oil price war between Saudi Arabia and Russia. The loonie’s decline feeds through to rising prices of imports. However, the pandemic has disrupted trade and imports have fallen.

The Bank of Canada suggested as well that they are meeting twice a week with the leadership of the Big-Six Banks. The cost of funds for the banks has risen sharply. CMHC is buying large volumes of mortgages from the banks, which, along with CMB purchases by the central bank, will shore up liquidity. The banks are well-capitalized and robust. The level of collaboration between the Bank of Canada and the Big Six is very high.

THE STOCK MARKET HAS HAD THREE GOOD DAYS

As the chart below shows, the Toronto Stock Exchange has retraced some of its losses in the past three days as the US and Canada have announced very aggressive fiscal stimulus. As well, the Bank of Canada has now lowered interest rates three times this month, with a cumulative easing of 1.5 percentage points. The Federal Reserve has also cut by 150 basis points over the same period. In addition to lowering borrowing costs, the central bank has also announced in recent days a slew of new liquidity measures to inject cash into the banking system and money markets and to ensure it can handle any market-wide stresses in the financial system.

The economic pain is just getting started in Canada with the spike in joblessness and the shutdown of all but essential services. Similarly, the US posted its highest level of initial unemployment insurance claims in history–3.83 million, which compares to a previous high of 685,000 during the financial crisis just over a decade ago. These are the earliest indicator of a virus-slammed economy, with much more to come. All of this is without precedent, but rest assured that policy leaders will continue to do whatever it takes to cushion the blow of the pandemic on consumers and businesses and to bridge a return to normalcy.

Dr. Sherry Cooper

DR. SHERRY COOPER

Chief Economist, Dominion Lending Centres
Sherry is an award-winning authority on finance and economics with over 30 years of bringing economic insights and clarity to Canadians.

STOCK AND BOND YIELDS PLUMMET AFTER SUNDAY FED CUT

General Michelle Foster 17 Mar

Fed Cuts Overnight Rate One Percentage Point But Markets Plummet

In an unprecedented Sunday afternoon meeting, the US Federal Reserve cut their key policy rate by 100 basis points (bps) to a level of 0%-to-0.25% (see chart below). Also, the Committee announced increased access to the discount window where the Fed makes loans to banks. The Fed is the lender-of-last-resort and is signalling that it will provide liquidity wherever needed. As well, with interest rates already so low, the Fed is well aware that rate cuts can only do so much. Thus, they are returning to quantitative easing–the buying of large volumes of U.S. government Treasury bills and bonds as well as mortgage-backed securities (MBS), to inject liquidity into the financial system.

The Treasury and US MBS markets are usually the deepest, most liquid markets in the world. But over the past two weeks, liquidity has dried up. Financial instability has risen sharply with the high level of volatility. Banks have experienced significant withdrawals as consumers are hoarding cash like everything else. The cost of funds to banks has risen sharply because of the enhanced perception of risk. With the collapse in oil prices, banks exposed to the oil sector are building up reserves for nonperforming loans. As businesses everywhere in nearly every sector shutdown, the risk of delinquencies rises further. Consumers who are housebound spend less money, and those who are freelancers or hourly wage earners might not get paid. Moreover, the shuttering of schools puts an added burden on parents who have no other daycare options for their kids.

All of this disruption, which according to the Center for Disease Control, could last months–the CDC recommended yesterday the shutdown of meetings of more than 50 people for eight weeks–has led to rising concern about the riskiness of banks. Bank shares have plummeted, and the yields on bank bonds have surged. Besides, banks and other mortgage lenders are fearful of being inundated with requests for refinancings, especially in the US, where penalties for breaking a mortgage are much lower than in Canada. Because of the refinancing surge in the US, the price of MBSs has fallen sharply, raising their yields and making the market highly illiquid.

The rising risk premiums, likely recession and illiquidity are causing banks in Canada and the US to raise some mortgage rates. Lenders are tightening the discount off the prime rate on variable-rate mortgage loans. Some fixed rates have edged higher as well. Such spread widening between mortgage rates and government yields happened during the financial crisis. Bank balance sheets will expand as troubled businesses and consumers extend their borrowings on their open lines of credit. Many will be unable to make timely interest payments. Loan loss reserves, already climbing, will rise further. Liquid deposits will be depleted as many are forced to live off of savings while shying away from selling stocks at markedly depressed prices.

These are not normal times. The Fed’s actions did nothing to calm markets. Indeed, stocks and bond yields plummeted in overnight trade, and the stock markets opened sharply lower in North America. The S&P 500 opened down over 8% while the TSX opened down 11%, triggering a circuit-breaker time out. This is the third time in a week the circuit breaker has hit. The TSX is down roughly 35% from its recent high (see chart below). The S&P 500 is down over 20%. The relative underperfomance of the Canadian stock market reflects our out-sized representation of the energy sector. The two weakest sectors in the TSX are the energy and financial sectors.

The world knows that the Fed and other central banks are running out of ammunition. Governor Powell said yesterday that he would not take the key fed funds rate into negative territory but instead would use “forward guidance” and asset purchases (quantitative easing) going forward.

The good news is that the banks are highly capitalized and much more resilient than during the financial crisis. Central banks since that time have put in place measures to monitor financial stability. Last Friday, the Canadian Office of the Superintendent of Financial Institutions (OSFI) reduced the capital requirements for Canadian banks to free up $300 billion for banks to support troubled borrowers. OSFI warned against the use of these funds to buy back stocks or raise dividends.

OSFI also suspended the proposed revision in the qualifying mortgage rate slated to begin April 6. The posted mortgage rate, published weekly by the Bank of Canada, will remain the qualifying mortgage rate. It is currently 5.19%, but it is expected to fall this week to around 4.95%.

But in these extraordinary times, there is a loss of confidence in the financial system. Some are calling for a full shutdown of the stock markets–but imagine the panic if no one could sell assets. There would truly be a run on the banks. Now is not a time to panic.

THE CANADIAN HOUSING MARKET
The Canadian Real Estate Association announced this morning that home sales recorded over the Canadian MLS Systems rose 5.9% in February, marking one of the more substantial month-over-month gains of the past decade. Actual (not seasonally adjusted) sales activity stood 26.9% above year-ago levels–keeping in mind that activity was quite weak one year ago. February 2019 marked a decade-low for the month, so a good part of the significant y-o-y gain reflects low levels of activity recorded at the time. February 2020 also benefited from an additional day due to the leap year.

The CREA President, Jason Stephen, said, “Home prices are accelerating in markets where listings are in increasingly short supply, specifically in Ontario, Quebec and the Maritimes which together account for about two-thirds of national sales activity. Meanwhile, ample supply across the Prairies and in Newfoundland and Labrador means increased competition among sellers.”

The number of newly listed homes jumped 7.3% in February compared to January, more than erasing the declines of late last year. New supply gains were posted in some large markets, including the Fraser Valley, Calgary, Edmonton, the GTA, Hamilton-Burlington, Kitchener-Waterloo, Windsor-Essex, Ottawa and Montreal.

The Aggregate Composite MLS® Home Price Index (MLS® HPI) rose 0.7% in February 2020 compared to January, marking its ninth consecutive monthly gain. The actual (not seasonally adjusted) national average price for homes sold in February 2020 was around $540,000, up 15.2% from the same month the previous year. See the table below for the regional move in prices.

But this is old news, particularly given all that has happened in the past two weeks. What comes next for the housing market? That depends on the course of the pandemic. Lower interest rates would typically be great news for the housing market, particularly for first-time homebuyers. But social distancing is hardly consistent with open houses and home shopping.

Moreover, volatility and instability reduce consumer confidence. Buyers that parked their downpayment savings in the stock markets have lost nearly a third of their money on paper. And how many sellers want a trail of strangers wandering through their homes during the pandemic. So the housing market, like everything else, is likely going to slow over the near term.

The Bank of Canada is hopeful that its rate cuts will stabilize the housing market from what might have otherwise been a substantial shutdown. Lower rates will filter through to lower monthly payments for floating-rate mortgage borrowers. Expect the Bank to cut rates again to near-zero levels, following in the footsteps of the Fed. So far, as of this writing, the Canadian banks have not responded to Friday’s BoC rate cut. The prime rate went down a full 50 bps on March 5 after the Bank cut its key rate by that amount on March 4. But so far, the Big-Six banks have not responded to the 75 bps cut three days ago.

Dr. Sherry Cooper
DR. SHERRY COOPER
Chief Economist, Dominion Lending Centres
Sherry is an award-winning authority on finance and economics with over 30 years of bringing economic insights and clarity to Canadians.

INTEREST RATES NOSEDIVE AS BANK OF CANADA CUTS RATES 50 BPS

General Michelle Foster 4 Mar

INTEREST RATES NOSEDIVE AS BANK OF CANADA CUTS RATES 50 BPS

The Bank of Canada Brings Out The Big Guns

Following yesterday’s surprise emergency 50 basis point (bp) rate cut by the Fed, the Bank of Canada followed suit today and signalled it is poised to do more if necessary. The BoC lowered its target for the overnight rate by 50 bps to 1.25%, suggesting that “the COVID-19 virus is a material negative shock to the Canadian and global outlooks.” This is the first time the Bank has eased monetary policy in four years.

According to the BoC’s press release, “COVID-19 represents a significant health threat to people in a growing number of countries. In consequence, business activity in some regions has fallen sharply, and supply chains have been disrupted. This has pulled down commodity prices, and the Canadian dollar has depreciated. Global markets are reacting to the spread of the virus by repricing risk across a broad set of assets, making financial conditions less accommodative. It is likely that as the virus spreads, business and consumer confidence will deteriorate, further depressing activity.” The press release went on to promise that “as the situation evolves, the Governing Council stands ready to adjust monetary policy further if required to support economic growth and keep inflation on target.”

Moving the full 50 basis points is a powerful message from the Bank of Canada. Particularly given that Governor Poloz has long been bucking the tide of monetary easing by more than 30 central banks around the world, concerned about adding fuel to a red hot housing market, especially in Toronto. Other central banks will no doubt follow, although already-negative interest rates hamper the euro-area and Japan.

Canadian interest rates, which have been falling rapidly since mid-February, nosedived in response to the Bank’s announcement. The 5-year Government of Canada bond yield plunged to a mere 0.82% (see chart below), about half its level at the start of the year.

Fixed-rate mortgage rates have fallen as well, although not as much as government bond yields. The prime rate, which has been stuck at 3.95% since October 2018 when the Bank of Canada last changed (hiked) its overnight rate, is going to fall, but not by the full 50 bps as the cost of funds for banks has risen with the surge in credit spreads. A cut in the prime rate will lower variable-rate mortgage rates.

Many expect the Fed to cut rates again when it meets later this month at its regularly scheduled policy meeting, and the Canadian central bank is now expected to cut interest rates again in April. Of course, monetary easing does not address supply-chain disruptions or travel cancellations. Easing is meant to flood the system with liquidity and improve consumer and business confidence–just as happened in response to the financial crisis. Expect fiscal stimulus as well in the upcoming federal budget.

All of this will boost housing demand even though reduced travel from China might crimp sales in Vancouver. A potential recession is not good for housing, but lower interest rates certainly fuel what was already a hot spring sales market. Data released today by the Toronto Real Estate Board show that Toronto home prices soared in February, and sales jumped despite low inventories. The number of transactions jumped 46% from February 2019, which was a 10-year sales low as the market struggled with tougher mortgage rules and higher interest rates. February sales were up by about 15% compared to January.

Dr. Sherry Cooper

DR. SHERRY COOPER

Chief Economist, Dominion Lending Centres
Sherry is an award-winning authority on finance and economics with over 30 years of bringing economic insights and clarity to Canadians.