Mortgage Rates Drop Amid Economic Uncertainty

Recent market volatility has led to trillions of dollars in equity value being erased, with the Japanese stock market experiencing its most significant collapse since Black Monday. Some predicted this situation as inevitable due to factors affecting financial markets and the broader economy. The push for immediate rate cuts by the US Fed has been met with criticism, citing historical precedents where such actions preceded recessions. Increased bond volatility could slow lender reactions, and an amplified risk would cause them to reduce their spreads. The ongoing turmoil in world markets is expected to result in increasingly tight credit conditions.

While surprising to some, it was an inevitable part of the economic cycle. Lower interest rates may be a potential outcome; however, they come at the cost of market instability and financial hardship. The impact of this volatility is far-reaching, affecting everything from bond markets and credit availability to consumer sentiment and housing affordability.

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Key Takeaways

• Global economic uncertainty, including a potential US recession, has led to decreased bond yields and lower mortgage rates in Canada.
• Despite lower rates, affordability remains a concern due to quantitative tightening and increased lender risk aversion.
• Borrowers can benefit from the current low rates but should carefully consider their long-term financial goals and choose the right mortgage terms and features.

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Why Japanese Rate Hike Triggered US Stock and Bond Markets

The past week has been tumultuous for financial markets. Poor corporate earnings and a disappointing US jobs report caused significant losses, erasing $2 trillion in equity from the stock market. This seemingly distant volatility directly impacts Canadian mortgage rates due to a phenomenon known as the carry trade.

The carry trade involves borrowing money in a country with low interest rates (like Japan) and investing it in a country with higher interest rates (like the US). This strategy can be highly profitable, especially when combined with fluctuations in exchange rates. However, it also carries substantial risk. If interest rates rise in the borrowing country or fall in the investing country, the profitability of the trade can quickly erode. Strengthening the borrowing country’s currency can also lead to significant investor losses.

Recent events have triggered the unwinding of carry trades. Rising interest rates in Japan and a strengthening yen have made these trades less profitable, leading to a sell-off of assets, including stocks and bonds, as investors rush to repay their yen-denominated loans. 

Example of Carry Trades

In January 2023, a hedge fund executed a carry trade using Japanese Yen (JPY) and US Dollars (USD). The fund borrowed 1 billion JPY at a low Japanese interest rate of 0.1% and converted it to approximately $7.8 million USD, assuming an exchange rate of 130 JPY/USD. This capital was then invested in US Treasury bills with a 4.5% yield.

The hedge fund aimed to profit from the interest rate differential between the two countries. The fund would profit substantially if interest and exchange rates remained stable or moved favourably (e.g., the USD strengthening against the JPY). In this scenario, the estimated annual interest earned would be $351,000. However, the carry trade also entailed risks. If interest rates were to rise in Japan or fall in the US, the profit margin would shrink. Moreover, a significant strengthening of the JPY against the USD could lead to losses when converting the USD back to JPY to repay the loan. This example illustrates the potential rewards and inherent risks associated with carry trades, which are influenced by fluctuations in interest and exchange rates.

This sell-off has contributed to market volatility and decreased bond yields, which could lead to lower Canadian mortgage rates if these conditions persist. However, the situation remains fluid, and future market movements will depend on various factors, including the trajectory of interest rates and exchange rates.

Canadian Mortgage Rates Fall as Bond Yields Tumble

Canada’s 5-year bond yield has dropped significantly recently, reaching its lowest point since May 2023. This decline has decreased mortgage rates, creating a favourable environment for borrowers. Several factors have contributed to this downward trend, including bleak economic data and a disappointing US jobs report in tandem with the Bank of Japan (BOJ) recently exiting negative rates, raising concerns about the possibility of a recession. 

The recent developments have led to a shift in expectations regarding future central bank policy rates, with investors anticipating rate cuts. Additionally, increased market volatility is reflected in a higher CBOE Volatility Index (VIX). This index shows what the market thinks about future price changes in the S&P 500 Index. It is based on the prices of index options set to expire soon, providing a forecast of volatility for the next 30 days. The impending rapid decline in stock prices has driven investors toward the perceived safety of government bonds. 

The rush for yield and safe-haven assets has significantly impacted the Canadian mortgage market. Mortgage rates have been marked down across various terms, with notable reductions in 2-year insured fixed, 3-year uninsured fixed, and 5-year uninsured fixed rates. While yields may experience occasional bounces, the current downtrend is expected to continue.

Canadian lenders are slashing fixed mortgage rates due to a significant drop in Government of Canada bond yields –  excellent news for those with mortgage renewals or refinances in the next two years. Variable mortgage rates have also decreased, thanks to recent Bank of Canada rate cuts. Experts predict further rate drops in the coming months as the BoC revises its forecast due to the slowdown in the US economy.

Economic Concerns and Market Volatility Fueling Rate Decreases

The Sahm Rule, a reliable recession indicator named after economist Claudia Sahm, has recently been triggered. The rule signals a recession when the 3-month moving average of the US unemployment rate rises 50 basis points (0.5%) above its lowest point in the previous year. This threshold was crossed as the unemployment rate reached 4.3%, its highest since October 2021. Despite the Sahm Rule’s empirical nature, markets have already priced in a recession. Investor concerns stem from the US Federal Reserve’s possible delayed response to cut the federal funds rate, which is at a 23-year high due to efforts to curb soaring inflation. 

However, Sahm doubts that the economy is contracting, citing growing household income, resilient consumer spending, and sustained business investment. The Sahm Rule trigger may nevertheless pressure the Fed to implement larger or earlier rate cuts than anticipated, with some analysts now predicting a 50 basis point (0.50%) cut in September, up from previous estimates of a 25 basis points decrease.

According to the Financial Times, recent economic data, including the latest US jobs report, suggests that the global economy may be slowing down more than expected due to high interest rates. This has led to concerns about a potential recession in the US, with Goldman Sachs increasing its probability forecast to 25%. Consumers are also starting to reduce spending, adding to the economic uncertainty.

According to CBS News, weak manufacturing and construction reports, coupled with weaker-than-expected job growth in the US, have stoked fears that the economy may be slowing down more than anticipated. This has led to concerns that the Fed’s aggressive rate increases may push the economy toward a recession.

Outlook for Canada’s Economy

The Bank of Canada recently updated its outlook for the Canadian economy and released its Summary of Deliberations from the July 24th policy announcement. The Bank stated that it sees the global economic outlook remaining largely unchanged, with growth expected to continue at around 3% and inflation gradually easing towards central bank targets. While the US economy has slowed, there’s potential for a rebound in consumption. Europe’s growth is stronger than expected, aided by tourism, but labour costs remain high. China’s domestic economy is weak despite strong exports. Financial conditions have eased globally with lower bond yields and resilient equity markets.

After initial weakness, the Canadian economy resumed growth in the first quarter of 2024. However, economic growth remains subdued and below potential. Population growth has supported spending on necessities, but discretionary spending is weak. The Canadian housing market is slower than expected, with an imbalance between demand and supply. The labour market shows signs of slack, with rising unemployment and increased pessimism about job prospects. Wage growth, while elevated, is expected to moderate. GDP growth is projected to pick up, driven by residential investment, consumption, and exports. Inflation has eased and is expected to continue moderating, reaching the 2% target in the second half of 2025.

Lower Rates May Not Improve Affordability

The Bank of Canada’s quantitative tightening will significantly impact the financial landscape as the BoC stated, “The Governing Council agreed to continue its policy of normalizing the balance sheet by allowing maturing bonds to roll off.” Quantitative tightening is a tool used by central banks to control the money supply, which can severely hinder affordability. The Bank achieves this by not renewing bonds as they mature, restricting the availability of loans and credit. 

Canadian banks are becoming more risk-averse, limiting funding access to all but their top clients. This makes borrowing money more challenging for individuals and businesses, even with low interest rates. The ripple effect is a decline in purchasing power, making goods, services, and assets like housing less affordable. Quantitative tightening can also trigger an economic slowdown by curbing spending and investment, potentially leading to job losses and income reduction, further exacerbating affordability issues.

Credit will be tightened between banks, financial markets, and borrowers, leading to restricted funds and a “credit desert,” reversing the wealth effect causing people to cut back on spending, particularly on big-ticket items. Market volatility will breed negative sentiment, further slowing down the market. Central banks may avoid intervention this time as it could have unintended consequences and hinder the market’s natural ability to stabilize. Despite the recovery from the August selloff, September and October could be turbulent, especially with the election looming in the US.

Government intervention, like the Bank of Canada’s quantitative tightening (QT), can significantly impact the economy, particularly in the housing market. Lower interest rates may seem beneficial but indicate a struggling economy and may not directly improve people’s lives. As Canadians navigate these uncertain times, it’s crucial to remember that everyone’s experience will be unique. The upcoming months will likely be difficult, but they also have positive change and potential hope for a fresh start. 

Choosing the Right Mortgage

Recent stock market fluctuations have sparked concerns about the economic outlook, but the potential for the Fed to cut rates could be good news for Canadian mortgage rates. If the Fed lowers rates, it could put downward pressure on Canadian bond yields, leading to lower fixed mortgage rates. Additionally, a lower-rate environment could stimulate economic activity, boost confidence, and potentially lead to increased competition among lenders, further driving down rates. While the market is experiencing some volatility, it has demonstrated overall solid performance this year, with gains of nearly 10% in the US stock market alone. While some indicators suggest a potential economic slowdown, others remain positive, and a full-fledged crash seems unlikely. With positive economic indicators and the possibility of rate cuts, there’s reason to be optimistic about the future of Canadian mortgage rates.

Market volatility can create uncertainty, but it also presents opportunities. Securing a pre-approval and locking in a low rate can benefit borrowers. It’s crucial to stay informed and seek advice from trusted sources. With the likelihood of further rate cuts, borrowers are presented with various term options. The 6-month term offers flexibility and a low qualifying rate, while the 1-year term suits short-term financial strategies. The 2-year fixed rate stands out as a competitive advantage, and the variable rate emerges as the most favourable. Borrowers should prioritize lenders with flexible policies and consider the ability to borrow more without penalty, floating or fixed payments, porting policies, and competitive conversion rates.

The recent drop in mortgage rates allows borrowers to secure favourable terms. However, it is crucial to consider individual circumstances and long-term financial goals when selecting a mortgage term. Borrowers can choose the right solution for their mortgage strategy by staying informed with mortgage rate forecasts and selecting the most suitable mortgage features. 

Are you still deciding whether to go fixed or variable or waiting for rates to drop? Nesto’s Prime Time can help you save with a discounted mortgage payment now while waiting to lock in later. Contact nesto’s mortgage experts to help you choose the best mortgage for your unique needs.

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