A drop in the inflation rate can bring hope to borrowers, but the persistently high home prices, which significantly impact inflation, complicate the Bank of Canada’s interest rate decisions. Current trends from the US market and anticipated rate cuts by the US Federal Reserve add another layer of intricacy. This mix of domestic and global economic factors creates uncertainty for those considering their mortgage options. Canada’s mortgage market and recent shifts, particularly those resulting from last week’s Federal Open Market Committee (FOMC) meeting, have likely influenced expectations for rate cuts in Canada.

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Key Takeaways

• Canadian inflation continues to cool, but shelter costs remain a concern
• US bond and stock markets significantly influence Canadian mortgage rates.
• The Fed’s anticipated rate cuts could trigger a similar response from the BoC.

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Inflation Cools, but Shelter Costs Linger

Recent information reveals a positive trend: Canadian inflation fell to 2.5% in July, marking the lowest since March 2021. This broad decline in inflation rates suggests that the Bank of Canada (BoC) might rethink its previously “higher for longer” stance on interest rates. The overall trend is promising, indicating a potential shift in monetary policy that could benefit consumers and the economy.

However, despite this optimistic perspective, challenges remain, significantly escalating housing costs, such as taxes, heating, condo fees and mortgage payments. Shelter costs, such as rent and mortgage interest, continue to exert more inflationary pressure even though they make up only 29% of the total CPI basket, accelerating to 5.7% in July. This persistent problem overshadows the good news about inflation, making it hard to accept the prospect of upcoming rate cuts fully. 

Fed’s Narrative for the American Public

There is currently a significant conflict in the narratives surrounding the financial markets, which became especially clear on Friday. During Jerome Powell’s speech, the bond and stock markets saw a notable rally, even though the Fed chairman’s remarks did not fully support the notion of significant interest rate cuts. This situation creates a delicate clash of viewpoints, and the Fed likely aims to steer the narrative toward a resolution that minimizes disruption in the financial markets on a backdrop that the era of near-zero interest rates is unlikely to return.

The bond market looks as if bracing for an impending recession as the yield on 10-year US treasuries drops below 4%. Inflation around 3% leads to an after-tax real return of less than 1%. The 1% return is significantly lower than historical averages, raising questions about the attractiveness of investing in bonds, mainly when the potential for real value growth takes an unreasonably long time. Conversely, stock investors seem optimistic about ongoing earnings growth, believing the economy will remain strong.

Nevertheless, the Fed has consistently signalled that while interest rates may decrease, the cuts will not be as substantial as bond investors expect. Despite recent low inflation rates, long-term trends suggest that inflation may stabilize closer to 3% rather than the Fed’s 2% target. The economy continues to grow, with job creation and low unemployment rates persisting, even after the US Bureau of Labor Statistics(BLS) revised last year’s total jobs growth downwards by 30%.

The Fed’s Rate Cuts Overture 

Investors in the US bond and stock markets, often overlooked in discussions about Canadian mortgages, actually play a vital role in influencing mortgage rates in Canada. There is a strong link between Canadian mortgage rates and American bond yields, meaning that changes in US market sentiment can directly affect borrowing costs in Canada. The US Fed has recently suggested that rate cuts might be coming, sparking speculation and anticipation among Canadian investors and homeowners. 

Fed Chair Powell’s comments about possible rate reductions, although lacking specific timing and scale, have certainly contributed to the market’s uncertainty and excitement. The effects of the US Fed’s decisions reach beyond the border, significantly impacting Canadian mortgage rates. As market participants in Canada closely monitor the Fed’s upcoming actions, the potential for shifts in US interest rates could lead to changes in Canadian household borrowing costs.

US CPI Noise and Data

Policymakers are at a crucial crossroads, trying to determine whether the recent economic signals are just background noise or if they indicate meaningful trends. Suppose inflation stabilizes around the Fed’s target of 2% or even dips lower, alongside signs of economic slowdown in the job market. In that case, it might be wise to consider easing monetary policy. Currently, money markets are split in their predictions, with many expecting a cut in short-term interest rates by either 75 basis points (0.75%) or more than 100 basis points (1%) by the end of the year.

While easing monetary policy is a reasonable strategy, the justification for such a decision isn’t significantly more potent than at the end of last year. There were signs of economic weakness, much like the current scenario, where some indicators still show strength. The inflation trends we’ve seen this year seem to echo those from both the first and second halves of 2023, particularly when we look at the price surges from January to April that distorted the inflation narrative but still contributed to a consistent rise in the Consumer Price Index (CPI) due to base-year effects.

Moreover, there are worries that the recent drop in consumer goods prices, which has played a crucial role in tempering overall inflation, might soon level off, stabilize, or reverse. Price changes are typical, and despite seasonal adjustments, the month-to-month fluctuations can mask genuine trends. The US CPI’s year-over-year change from June 2022 to June 2023 was 3.1%, while the change from July 2023 to July 2024 slightly dropped to 2.9%. This slight decrease is mainly due to a notable slowdown in rental inflation south of the border based on signed leases that are consistently tracked.

Mortgage Affordability in Canada

There are signs that Canadian home prices may begin to fall as more properties come onto the market and buyers struggle with affordability. The timing of the Fed’s decision to lower interest rates will be crucial in shaping the overall economic landscape here in Canada. While new mortgage originations have increased year-over-year, they remain below the typical levels expected for the 2024Q2. A housing market indicates buyers are cautious due to the high interest rates. Additionally, a significant portion of mortgage demand will likely shift into 2025, which could lead to increased market activity as we near the fall season.

Despite a drop in home sales, the average mortgage amounts have risen, reflecting the higher home prices. First-time buyers are particularly feeling the pinch, as the average mortgage amount has climbed to $410,000, requiring substantial savings and extended periods to accumulate enough for a downpayment. Many homeowners face mortgage renewal payment shock, which could strain household budgets and challenge consumer spending.

Moreover, the number of adult children living with their parents has increased, likely due to the difficulties in the housing market and broader economic uncertainties. Credit card debt has also surged to levels not seen since 2007, particularly among those with mortgages, highlighting a growing dependence on credit and potential financial stress. As interest rates are projected to decrease, homeowners burdened with high mortgage payments and credit card debt may seek to refinance, potentially leading to a significant uptick in refinancing activities. High home prices, higher interest rates, and affordability challenges all combined could prompt a correction in the housing market, resulting in price drops and reduced sales. Impending financial pressure may also influence changes in consumer spending habits.

Variable Rates Offer a Tempting Gamble in a Falling Rate Environment

Economic and mortgage rate forecasts for Canada and the US suggest that further interest rate cuts are likely. This trend makes variable-rate mortgages (VRM) more appealing to borrowers, as they could benefit from the declining rates established by the Bank of Canada. While variable and adjustable mortgages may begin with higher rates, they present the opportunity for lower mortgage payments if the BoC opts to reduce rates, making them an attractive choice for those comfortable with some fluctuations in their mortgage interest costs.

Fixed Rates Offer Short-Term Security Paired With Long-Term Uncertainty

Fixed-rate mortgages, particularly those with shorter terms, can be an excellent option for those prioritizing stability in their interest rates. Currently, 5-year fixed rates are low, offering borrowers a sense of security in the short term. However, with the potential for significant drops in prime rates on the horizon, shorter fixed-rate options might provide even more advantages once bond yields follow the prime rate’s lead. Borrowers need to consider their fixed-rate mortgage terms and conditions, specifically their prepayment penalty calculations, and weigh the benefits of a fixed rate against the possible savings from lower rates if they decide to switch or renew early.

In Conclusion

Borrowers can navigate and secure favourable mortgage terms by thoroughly evaluating their options and making well-informed choices. Reviewing your fixed-rate mortgage is crucial as the small details can significantly impact overall borrowing costs, especially when the central bank changes policy rates.  In Canada, the mortgage market is continually evolving, offering distinct opportunities and hurdles for borrowers. Given the uncertainty of future mortgage rates and the swift shifts in economic conditions, remaining updated and consulting with mortgage experts can be vital to developing the best mortgage strategy.

Canada’s mortgage market is dynamic, and professional guidance can be invaluable in choosing your mortgage strategy. Reach out to nesto mortgage experts and lock in your best mortgage rate. 

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At nesto, our commission-free mortgage experts, certified in multiple provinces, provide exceptional advice and service that exceeds industry standards. Our mortgage experts are non-commissioned salaried employees who provide impartial guidance on mortgage options tailored to your needs and are evaluated based on client satisfaction and advice quality. nesto aims to transform the mortgage industry by providing honest advice and competitive rates using a 100% fully digital, transparent, seamless process.

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Contact our licensed and knowledgeable mortgage experts to find your best mortgage rate in Canada.

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