The Market’s Message: Go Short, or Variable

Rate forecastingWhat the inflation market is currently pricing is an incredibly benign inflation trajectory in the next 10 to 20 years.

Martin Hegarty, head of BlackRock’s inflation-linked bond portfolio in New York, told that to Reuters this week in a story entitled Markets predict decades of inflation frustration.

“We are pricing a…rate that implies the Fed will miss its inflation target for a very, very long time—and not only a miss, but miss by a very wide margin.”

As you regular readers know, low inflation signals low mortgage rates.

Now, we don’t normally put a lot of weight in analyst rate predictions. History has discredited most long-term rate forecasting. But we do buy into this one, for two reasons:

  1. The market itself is making this call, not an economist. (The yield curve—i.e., the range of interest rates on short to long-term government securities—factors in all known information about what the future may hold. It has statistically significant—albeit far from foolproof—predictive power.)
  2. There are major structural economic changes keeping inflation at bay, including those mentioned last week.

As of this writing, the market is speaking loud and clear with Canada’s 10-year yield all the way down to 1.08%.

That yield “should equal…the [geometric] ‘average’ of the Bank of Canada’s overnight rate over the coming [10] years, plus a term premium,” notes Brian Romanchuk, CFA, publisher of BondEconomics.com and author of Interest Rate Cycles: An Introduction.

Jargon Buster:Term Premium” refers to the compensation that investors require for tying their money up in a longer-term bond, which is inherently more risky than a short-term bond.

So, what specifically does a 10-year bond at 1.08% imply about Canada’s overnight rate in the next decade?

Economic-PredictionsSays Romanchuk: “The most reasonable implication is that the markets are pricing in an expectation that the average of the overnight rate [will] be around 0.50 to 0.90% over the next 10 years. There is no consensus for the term premium, but that range indicates what I think is reasonable.”

Imagine for a second that we knew this to be true. Imagine if we could be sure that Canada’s key lending rate would not average more than a half point higher through 2026. There would be almost no reason to get a fixed rate longer than one to three years.

The question of the year is, how much should we believe what the market is telling us?

The answer is that the balance of evidence concurs with the bond market. While not a surefire system for selecting mortgage terms, the current yield curve is just one more piece of evidence that argues in favour of shorter and variable mortgage terms for qualified borrowers.

Just remember that short-term inflation spikes can and will occur. That could easily take rates up over one percentage point in less than 12 months. But if you stick to your guns and ride the wave in a variable rate1-year fixed or 2-year fixed, you should come out ahead with a lower average rate than a long-term fixed—if history, disinflationary trends, the Bank of Canada’s inflation fighting policy, academic research and the yield curve are a guide.



15 Comments

  • AS says:

    Thanks Spy-guy. Your advice as always is top-notch. I’m in the market for a renewal on an uninsured mortgage of 400K in Ontario and can handle the risk of a rate increase. Assuming you could get a 2-year fixed term for 2%, what kinds of variable and 5-year fixed rates would make those options serious contenders?

  • The Spy says:

    @AS

    Always a pleasure. As for your question, let’s first suppose you’re comparing a 2-year fixed to a 5-year variable. Four reasons for going variable would be:

    A) You don’t want to worry about renewing in 20-22 months;

    B) You think short-term/variable discounts won’t be as good when you renew in two years;

    C) You want the flexibility to lock into a fixed rate whenever you want, without penalty; and/or

    D) You think prime rate will drop.

    Re: “A” — Ideally you want to ensure you’re saving enough in the 2-year term to help justify the more frequent renewals.

    Re: “B” — Shrinking discounts can definitely happen—as we saw in 2011 for example—but it’s a small probability. Most of the time you can find either a decent 1- or 2-year rate, or a good variable rate, or both. It would take a very adverse capital markets event to wipe out discounts on 1- and 2-year fixeds, and variable rates.

    Re: “C” — Locking in a variable to a fixed entails a lot of slippage. In other words, the new fixed rate won’t be exceptional. That’s because the lender knows you have to pay a penalty to get a better 5-year rate elsewhere.

    Re: “D” — If banks do cut prime it’ll be marginally. Don’t bet on more than 0.15% to 0.30% in the next few years. A few bankers I’ve spoken with actually believe the Big 6 might not pass along any further Bank of Canada rate cuts below 0.50%. But that would cause riots in the streets.

    All that said, the flexibility of being able to pay out or renegotiate a mortgage in two years has benefits. For one thing, you can refi at best rates and/or pay off big chunks with no penalties. For another, variable-rate discounts might actually improve in 24 months. So unless the current variable rate were lower, I’d (personally) stick with the two-year. This assumes both mortgages have equal feature-sets and restrictions.

    As for a five-year fixed, that’s not a term that most informed risk-tolerant, financially stable borrowers even consider. It’s a different mindset altogether from a 2-year and a variable. But if you’re just trying to quantify the risk, the breakeven is roughly 0.75% (assuming a 2.39% five-year fixed rate). In other words, rates would have to jump over three-quarters of a point in two years for the 5-year fixed to cost you less (other things equal).

    Is that possible? Of course. Would most people bet on it given the contained inflation environment we’re in? Nosir.

  • Willy says:

    Hello The Spy,

    Love your site and your deep knowledge of mortgage related stuff.

    I have a question: I’ve got a choice between 5-years fixed @ 2.29% or 2-years fixed @ 2%. I know you’ve been saying that 2-years fixed makes the most sense but @ 2.29%, all it takes is a .25% increase in the first 2 years to make it worth it (or at least not worse) versus the 2-years.

    Would you still go for the 2-years fixed versus a 5-years fixed @ 2.29?

    • The Spy says:

      Thx Willy,

      My prior message on the 2yr vs. 5yr was based, in part, on a 0.40 percentage point spread between the two.

      If the spread were 0.29 pp instead, like your example, the breakeven would actually be a 0.50% rate hike in two years.

      The smaller the breakeven, the greater the relative importance of other factors, like limiting your upside rate risk, avoiding renewal hassle in two years, etc. The cost of that 5yr benefit (if you want to call it that) is roughly $550 in extra interest over the first two years (compared to a 2yr term), per $100,000 of mortgage.

      Of course, the suitability of a 5yr fixed also hinges on your likelihood of moving or refinancing in five years. If that likelihood is meaningful, the expected cost of a 5yr term goes up, other things equal.

  • Christine says:

    Hello,

    I have a question. If you were offered 2yr fixed and 5yr variable at the same rate of 1.94%, which one would you pick?

  • The Spy says:

    Hey there Christine,

    Assuming:

    a) the mortgage features and terms are similar, and
    b) the borrower doesn’t plan any mortgage changes in the next 24 months,

    …then this call would depend on things like the:

    * Odds of needing a bigger mortgage before 5 years
    * Odds of moving in years 3-5
    * Odds of wanting to lock in to a long-term fixed rate at some point
    * Job/income stability, debt ratios and credit (i.e., can the borrower easily re-qualify in two years?)
    * Desire to go through the application process again
    * Closing cost of the 2-year mortgage at renewal.

    For a very well qualified homeowner, a two year offers more flexibility if he/she anticipates coming mortgage changes or wants to renew sooner into potentially better discounts (despite the small risk that discounts might shrink).

    A variable, on the other hand, eliminates the need to spend time and money renewing in two years. It also lets the borrower capture rate drops sooner, if they occur.

  • Brook says:

    Hi Spy,

    I have to renew an existing mortgage this week, looking for advice re: Variable vs. Fixed.

    My current lender bank is offering 2.49% for a 5 yr fixed, 2.34% for a 4 yr fixed, or 5 yr variable at -0.40 discount off posted rate (which would be 2.3% after discount). I think 2 yr fixed would be 2.29%.

    I’ve gone 5 year variable in the past and benefitted from rate drops over the past 10 years (currently 1.85%). Now with rates so low, looking for some advice.

    Remaining amortization (if I keep it the same) is 154mths, and balance is $189K.

    Thank you

    • The Spy says:

      Morning Brook,

      Step one is always to comparison shop. The rates you’ve listed are average to above average. Note that a 15 basis point (0.15%) rate savings is about $1,200 over five years on a $189,000 mortgage with 12.8 year amortization.

      That may or may not be enough to justify switching lenders. It depends on the current lender’s service and mortgage contract, the borrower’s future plans, and on what costs the new mortgage provider will cover.

      Comparing terms like this requires certain borrower assumptions: stable income, low non-mortgage debt, 20%+ equity, sufficient savings, no need for mortgage changes within five years and a reasonable risk tolerance. That’s often not the case, but assuming it is, there’s no value (for most people) in a 2.30% variable or 2.34% four-year.

      That leaves the five-year and two-year. It would cost roughly $700 of extra interest in the first two years with a five-year fixed at 2.49% (using the above assumptions). Only you can determine if that’s a reasonable cost for the assurance of knowing your rate 3-5 years from now.

      If your current lender meets your needs, try to use RateSpy’s rates as leverage to hammer them lower on the 5yr and 2yr.

      Good luck!

  • Brook says:

    Thank you so much! I’ll use RateSpy as leverage with RBC (the RBC rates you’ve listed are actually lower, 2.44/5yr fixed, 2.25/5yr variable).

    Here’s our assumptions: stable incomes, $20K debt, 20%+ equity (market value is around $800K), ok savings, thinking about moving within five years (low probability), reasonable risk tolerance.

    Currently have mortgage + HELOC (that’s the $20K debt) with RBC, and prefer to stay with them for the online convenience and service.

  • Willy says:

    I’m with RBC too right now but will need a new mortgage in October. I’ve got an offer for a full featured 5-years fixed @ 2.29% with another lender (15%/15%/double up) so their features are much better than RBC’s. Unless RBC can give me 2.29% I don’t see why I’d stay with them. Yes the HELOC is great but the “easy money access” is a bit too tempting at times 😉

  • The Spy says:

    Hi Willy,

    You might be able to find a better rate *with* a HELOC (if that’s what you want). You can certainly find a 5+ bps lower full-featured 5y rate without a HELOC.

    Naturally, you’ll also want to factor in switch costs, including legal fees (if you have a HELOC now), discharge fees, and the appraisal cost (if your new lender/broker) isn’t picking it up.

  • Willy says:

    Hello The Spy,

    Are you sure about that? I’m in Quebec and it seems the lowest I could go (for a 5-years fixed) is 2.29. It’s a bit lower in some other provinces. But maybe I ought to do some extra hunting 🙂

  • The Spy says:

    Hey Willy, I’d call the four providers advertising 2.29% in Quebec and see what they can do: https://www.ratespy.com/best-mortgage-rates/5-year/fixed

  • Brook says:

    Hi Spy,

    Renewed today for 2 yrs fixed/closed @ 2.04%. Offered 5 yr variable @ 2.25%, but based on the more flexible options at the end of 2 yrs I chose the fixed 2yr.

    Thanks to info. from your site, I determined that variable rates likely won’t increase for a couple of years (if they did and I chose to lock in, I’d lose on the conversion rate), and if they go lower the bank will only pass along max .10 to .15%. With bond rates going as they are, may equate to lower fixed rates in about 2 years, and at that time I can re-finance with another term length of my choice, fixed or variable. So I saw the 2yr @ 2.04 as most favourable.

    Thanks

  • The Spy says:

    My pleasure. Love your logic, Brook. 2.04% is solid.
    Well done.

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