As consumer demand drops for goods and supply chains improve, prices of economic inputs such as copper, steel, silver, lumber, microchips, shipping costs and many other commodities have fallen drastically. These trends are very anti-inflationary. However, food costs continue to be inflationary, with energy/gas costs also generally higher. With a slowing economy, there likely will be a point later in 2023 or early 2024 when these more inflationary areas of the economy cool off.
It is known in economics and recently mentioned by the Central Bank of Canada that it takes 12-24 months for a single interest rate hike to ‘trickle through’ or have a full effect on slowing an economy. While the first small 0.25% interest rate hike in Canada happened in March 2022, as of September 2023, we have not seen the full effects of the rate hikes of 2022. More likely, we have only seen about half of the potential effects of current Central Bank interest rate hikes.
As 2023 comes to a close, we will likely see the effects of last year’s increases build momentum.
So it is important to keep in perspective that:
(1) The previous rate hikes we have seen have not had their full effect on slowing the economy, and we are already seeing a recession on the horizon.
(2) It is a matter of how long Canada can withstand such high rates before there is a significant negative economic impact.
Accordingly, the question is becoming more about how long these high rates will remain. The unfortunate answer is likely until the economic resilience we have been witnessing in discretionary spending is suppressed.
Once the economy slows to the point of recession, there is a better potential for inflation to drop to 2%, and at this point, there is an expectation of a sustained rate drop cycle. As of October 2023, the financial markets think it will take about 9 months. However, it could very well take more or less time.
So, what does this mean for mortgage rates?
What goes up to slow the economy will eventually come down to stimulate the economy.
The Central Bank of Canada (and the Federal Reserve in the USA) is determined to fight inflation, which is why they are seen as slamming the breaks on the economy as a whole. There is no doubt this, unfortunately, will be painful for many. However, low inflation is needed on a foundational level to enjoy another long-term run of low interest rates.
Eventually, the Central Banks will begin lowering rates again to stimulate the economy and pull us out of the recession. This means lower mortgage interest rates.
More specifically, after the Central Bank has reached its peak or ‘terminal rate’, historically, it takes on average 6 months for the Central Bank to start lowering rates again. However given the stickiness of current inflation, instead of increasing rates further, the Central Bank may decide to leave rates at 5% for longer.
In October 2023, Bond markets are projecting the first Central Bank rate drop in July 2024.
At this point, the expectation for the first Bank of Canada interest rate drop is projected out long enough that financial markets are essentially saying that they are waiting for conclusive evidence of a recession or major economic slowdown. In other words, markets may have gone from being overly optimistic, anticipating a rate drop, to a more cautious ‘wait and see’ type position. Given the current economic data, a recession could happen at any point in late 2023 or early 2024, prompting a sudden drop in bond yields and fixed mortgage rates.
It’s important to note that once rates begin to fall – this can spur inflation again. For this not to happen, the job market likely needs to cool further or for a more substantial correction.
Also, Canada needs to work in step with the US economy and their Fed rates. Otherwise, the Canadian dollar could sink substantially, which can cause inflation. In other words, even though Canada will likely enter recession before the US, the Central Bank of Canada may hold out a bit longer to drop the overnight rate, until a US recession is imminent.
While the variable rate mortgage is directly affected by the Central Bank decisions, we will likely see 3-5 year fixed rates generally trend lower in late 2023/early 2024. Because fixed rates are ‘pegged’ to the Government of Canada Bond Yields and Bond Yields trade in anticipation of Central Bank rate decisions, we will likely see rates float lower, but not in a straight line.
For example, fixed rates were mostly in the high 5% range in November – December 2022. But then dropped to the mid 4% range throughout January 2023 and remained in this range through to mid May. In June, fixed rates have mostly trended back into the 5% to low 7% range (depending on the term selected), as bond yields priced in the first rate drop further out into 2024.
It’s not a matter of if, but when there is another significant downturn for fixed rates, and as of October 2023 we may have another 2 – 6 months until lower fixed mortgage rates.
Rates will not normalize at the lowest levels seen during covid. However, as fixed mortgage rates generally remain in a restrictive 5-7% range, the expectation is that rate normalization may occur into the mid-high ‘neutral rate’ range or in the high 3% – low 4% range for mortgage rates.
The CIBC Capital Markets projection from April 2022, seen just below, illustrates a good representation of this forecasted rate trend. However, given stubborn inflation, the Central Bank rate peak will clearly be higher than in the numbers indicated in the chart: