Broker offers his take on BMO’s forecast

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Assumption #2: “The weakening Canadian dollar and upward risks to commodity prices from geopolitical uncertainty … could put pressure on prices to rise … [and] force the Bank of Canada to raise interest rates more aggressively.” 

While geopolitical uncertainty could weaken the dollar, recent evidence suggests that the reverse might also occur. Over the past several years just about any type of rising uncertainty has increased demand for safe-haven assets, and Government of Canada (GoC) bonds consistently appear near the top of that shrinking list. We could therefore easily see foreign investment flood into the country in response to rising geopolitical tensions and that would drive the Loonie higher.

I also don’t subscribe to the thinking that higher commodity prices are likely to force the Bank of Canada (BoC) to raise rates.

First off, China is the world’s marginal buyer of most commodities and it is trying to move its economy away from the capital investment-led growth that it has relied on throughout its most recent economic boom period. It was the Chinese investment in capital goods that supported strong and growing commodity prices and the shift away from this form of investment is a long-term trend that should have much more impact on commodity prices in the coming years than the current tensions in Crimea.

Second, even if commodity prices do rise, the BoC has repeatedly told us that it will allow inflation to remain either above or below target for an extended period if circumstances warrant. If rising commodity prices caused by a geopolitical crisis push our inflation rates higher, raising our short-term rates would have no impact on the source of this inflationary pressure. So why would the BoC raise short-term rates and create the additional headwind of higher borrowing costs?

Anything is possible, but I think it is unlikely that events will unfold in this way.

Assumption #3: “Fixed rates are attractive because short-term rates are already at extreme lows.”

This is an oft-used refrain for the argument in favour of fixed rates. The thinking goes that if short-term rates are at all-time lows they can only go higher, so better to lock in a fixed-mortgage rate before that happens. But this is specious reasoning unless it accounts for the timing of when rates might rise.

For example, short-term rates reached extreme lows in Japan in late 1995 and are still there today. Anyone who chose a Japanese fixed-mortgage rate since then has paid more than they would have with a variable-mortgage rate, despite the fact that Japan’s short-term rates were at extreme lows throughout this period – just as the BoC’s overnight rate is now.

We don’t need the Japan-type deflation scenario, or even for the BoC to keep overnight rates at all-time lows indefinitely, for a variable-rate mortgage to win out over a fixed-rate mortgage over the next five years. As long as the variable rate stays low for the next twelve to eighteen months, it can rise fairly quickly after that and variable-rate borrowers will still come out ahead.

I ran a fixed versus variable rate scenario recently to illustrate how quickly five-year variable rates would have to rise before losing their advantage over five-year fixed rates. (The five year fixed rate I use is 3.35%, which is admittedly out of date, but so is the 3.49% rate the BMO economists used in their report.) Using the simulation, you can judge for yourself how realistic my forecast is and then gauge the likelihood that the BoC would raise its overnight rate even faster than my forecast assumes. For my part, I think my forecast errs on the aggressive side because we have record levels of consumer debt today which will exacerbate the economic impact of every BoC rate increase.

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