Friday, January 14, 2011

Right and wrong with rates

Lately, there has been a lot on the new and media about rates and debt levels of Canadians.  Finance minister Flaherty has daily been hammering Canadians into believing the debt levels are too high and that rates are going to soar.  According to his reports, when this happens, we will all be bankrupt and destitute.  I am not a big fan of his scare tactics, but I also think he is functioning on the "conservative side". 

The experts are now saying rate increases will happen at the earliest in July 2011 and will be a quarter point increase or less.  There could be quarterly increases afterwards of 0.25% or less.

I think the leading economic indicator we have to follow is US unemployment.  Until we start to see consistent drops in US unemployment, we will not see the US fed increase their lending rates. 

The problem for Canada is our soaring dollar.  For the manufactoring sectors, the dollar is best under $0.90 USD.  Canadian government controls monetary policy, that influences the exchange rate.  The simplest form is buying up surplus Canadian dollars or selling off Canadian dollars to the marketplace.  Less dollars available make them more desirable, more dollars makes them less desirable.

The second is interest rate policies.  Right now, the interest rate in Canada is higher than in the United States (particularly after each country’s rate of inflation is taken into account). This means that lenders can get a higher rate of return for lending in Canada than in the United States. In order to take advantage of this higher rate of return, international investors will shift their portfolios (for example, government bonds) from the United States to Canada.


These sorts of shifts cause an increase in demand for Canadian dollars. In order to buy Canadian government bonds, investors first have to purchase Canadian dollars; the result is an increase in the demand for Canadian currency. Meanwhile, the demand for the US currency would fall as investors divest themselves of US government bonds in order to reinvest that money in Canada, where they can gain a higher rate of return. The overall result: a rise in the value of the Canadian currency relative to its US counterpart.

As such, the Bank of Canada can attempt to influence Canadian dollar exchange rates by manipulating the interest rates. If the Bank wishes to stop or slow a drop in the value of the Canadian dollar, it may raise interest rates to levels higher than in other nations; this, in turn can spur investment in Canada relative to other nations and demand for the dollar. Conversely, if the Bank wishes to stop or slow a rise in the value of the dollar, it can do so by lowering interest rates below other countries, thus causing lower relative investment and demand for the dollar.

The other consideration is inflation.  A bottle of pop in the 1950s was $0.10, now a bottle of pop is $1.50 meaning pop has experienced a 15x inflation.  Canada aims for 2% annually.  In order to control inflation, the Bank of Canada actively pursues inflation targets, and does so by manipulating interest rates (or the cost of borrowing) and consumers' spending habits.  Low inflation increases demand for investing in Canada and high inflation disusades investing in Canada. 

As you can see, mortgage rates are a confusing thing to figure out.  Simply raising rates in one area, can be counter productive in other areas.  Throw in that monetary policy from Barrack Obama seems to be leading into the US flooding the market with Greenbacks, it is unlikely to see the USD climbing in the near future. 

I think as an investor in Canada, I would watch rates closely.  I would stay variable at this point.  Every month you lock in on the front end, is a month you miss out on the back end.  Think of it this way, you are currently paying 2 to 4% right now, in 5 years rates could be as high as 7 to 9%.  Imagine the difference if you give up 6 months or a year at 3% and get to pay 9% on the backend for that period.

Now that you are totally confused, and still wondering what to do, let me be more simple.  I think the short term is to remain variable.  Once US unemployment starts to drop, I think it will be time to watch very closely the idea of converting to a closed rate. 

Never in the history of mortgages has a 5 year closed mortgage outperformed a 5 year variable mortgage.  I think at some point in the future, I we will see one period like this as we adjust through the US financing crisis.

One point of difference that I would like to cover ... remember, variable mortgages fluctuate in relationship to prime lending rates.  So if you can get a prime - 0.5% mortgage and current fixed mortgage rates are 3.89% that means prime would have to reach 4.39%, whereas right now prime is 3%. 

That means an increase in rates of 1.89%.  Usually the rates increase by 0.25% per quarter, so we are looking at a minimum of 8 quarters, or two years before variable rates equal fixed rates.

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