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Expectations for higher rates are rising, but how long will higher rates last?

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While fixed mortgage rates continued to rise last week, variable rate holders should see their own increase next week, with the Bank of Canada potentially on track to raise rates by 50 basis points.

All of Canada’s Big 6 banks now expect the Bank of Canada to raise its target for the overnight rate by 50 basis points next week, bringing its key rate to 1.00%.

This follows the quarter-point hike the BoC announced in March and would be the first half-point rate hike since 2009. Some economists expect this to be followed by another up 50 basis points in June, while others see a more gradual pace of tightening to bring the overnight rate down to 2.00% by the end of 2022.

Bond markets, meanwhile, are seeing the overnight rate rise even more aggressively to 2.50% by the end of the year, 200 basis points higher than today’s level. .

“Although inflation and wage pressures in Canada are more subdued compared to their US counterparts, the environment and risks are definitely elevated. Equally pressing is the need to raise policy rates in Canada,” TD economists wrote in a recent Remark. “Just like with the Fed, the Bank of Canada (BoC) is coming from behind the inflation curve, creating greater urgency to anchor expectations.”

However, not everyone is convinced that these aggressive projections will hold.

“At this point, the market is pricing in a rapid upward trajectory, with both central banks expected to reach 85% of their respective terminal rates over the next 12 months. We think that is far too fast. wrote Benjamin Tal and Katherine Judge, CIBC economists.

“While central banks have now committed to hike rates, we are seeing a much earlier pause in the up cycle as Powell and Macklem begin to pay more attention to the slowing economy, instead of continuing. to chase a lagging indicator. [inflation].”

Are today’s higher rates temporary or here to stay?

As mentioned above, fixed rates have continued to climb over the past week, gaining another 10 to 25 basis points. Among the major banks, TD, BMO and the National Bank of Canada made further rate hikes.

Average uninsured 5-year high discount fixed rates are now just under 4.00%.

With fixed mortgage rates likely to rise above the 4% mark and variable rates expected to follow and narrow the gap in the coming months, some are wondering if higher rates are here to stay or if it is of a temporary peak.

“The question now is whether we have entered a new era of steadily rising bond yields or whether this is just a short-term failure before returning to the long-term trends of our weak economy. growth, low inflation and low interest rates,” he added. wrote mortgage broker Dave Larock of Integrated Mortgage Planners.

“There’s no guarantee that the past is prologue, but it seems reasonable to assume that the sources of today’s inflationary pressures will eventually subside, and when they do, inflation could fall. dramatically – as well as the bond yields and mortgage rates that are set on them,” he added.

This is an important consideration for borrowers who are faced with the difficult decision of whether to go fixed or variable.

Those who choose a long-term fixed rate run the risk of getting stuck at a peak, like what happened to borrowers in the spring of 2020 when fixed rates rose but eventually fell back to record lows.

Larock noted that borrowers who got 5-year fixed rates above 3% in the spring of 2020 locked in high. Some who were with “fair penalty” lenders opted to break their mortgages to take advantage of lower rates, while others were effectively locked in with their rates due to prohibitive prepayment penalties.

When will we reach the Bank of Canada’s neutral rate?

Much depends on when the Bank is able to reach its target neutral rate, which is the level where the economy is at full strength and inflation is on target, or 2.25% in the Bank’s case. from Canada.

“In practice, as they enter a tightening cycle, central bankers don’t know for sure where the neutral rate is, but they know it when they see it,” CIBC economists said. wrote in a note entitled Rising Canadian Rates: Where’s the Finish Line? “A slowdown in the economy that threatens to pull it away from a full employment starting point, or a drop in inflation below target, may indicate that rates are above neutral. “

The question is, how likely is the next recession, which could end up reversing the Bank of Canada’s rate hikes and pushing mortgage rates down again? Closely watched indicators signal a growing risk that a downturn is on the horizon.

Last week, 10-year US Treasury yields fell below 2-year yields. When the rate of short-term bonds falls below longer-term bonds, this is called a reversal in yields and often serves as a warning of an upcoming recession.

“With the yield curve implying increasing recession risk, there is a good chance that the prime rate will return to its 10-year average within 36 to 48 months,” said rates analyst Rob McLister. Noted.

“For this reason, borrowers who lock into fixed rates in the mid-to-higher 3% range need to balance unexpected inflation/rate risk with recession risk,” he said. “As rates approach 4%, some would say the outlook is tilting towards the latter risk.”

That said, McLister added that inflation could prove “much more persistent than central banks expect, which could leave rates above “neutral” for most of the next five years. »

For this reason, he argues that “insurance” in the form of longer-term fixed rates is still an appropriate choice for the most risk-averse borrowers.

Latest rate predictions

Here are the latest interest rate and bond yield forecasts from the Big 6 banks, with any changes from their previous forecasts in parentheses.

Target rate:
End of year ’22
Target rate:
End of year ’23
Target rate:
End of year ’24
Yield on 5-year BoC bonds:
End of year ’22
Yield on 5-year BoC bonds:
End of year ’23
BMO 2.00% (+50 basis points) 2.50% (+50 basis points) N / A 2.60% (+75 basis points) 2.70% (+45 basis points)
CIBC 1.75% (+50 basis points) 2.25% (+50 basis points) N / A N / A N / A
NBC 1.50% 1.75% N / A 2.00% 1.95% (-10 basis points)
RBC 2.00% (+75 basis points) 2.00% (+25 basis points) N / A 1.85% (+35 basis points) 1.95% (-15 basis points)
Scotland 2.50% 3.00% N / A 3.00% 3.10%
TD 1.75% (+25 basis points) 2.00% (+25 bps) N / A 2.20% (+10 basis points) 2.05% (+5 basis points)