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“Our message to Canadians is that interest rates are very low and they’re going to be there for a long time”
Bank of Canada Governor Macklem - July 2020

Forward guidance at its finest. Less than two years later, the Bank of Canada embarked on an aggressive rate hike cycle. They're not done yet either.

The pace is only matched by the Fed and the RBNZ, who hiked another 75bps this week while forecasting a year-long recession to bring inflation down 👇

It was an INSANE commitment for any central banker to make. Yes there were some mitigating circumstances at the time. Things looked bad. Years of low inflation, add in some Covid uncertainty and the much-feared Japanification looked a sure thing.

We all know what happened next. Central banks and governments decided that doing too much was better than doing too little. We got stimulus on steroids.

Economies were out of balance, and the lesser-spotted inflation - once thought at risk of extinction - is now everywhere.

There’s no inflation round ‘ere!

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Yesterday, Governor Macklem was talking up even more hikes, even though he reckons (hopes?) the finish line is in sight... 👇

"This tightening phase will draw to a close. We are getting closer, but we are not there yet"
"Inflation has come down in recent months, but we have yet to see a generalized decline in price pressures"

The central bank also published some eye-opening, and quite concerning research on Canada's mortgage situation. It turns out that approximately three-quarters of variable-rate mortgages in Canada have fixed payment clauses.

Variable rate mortgages with fixed payments sounds like an oxymoron. It's weird but pretty simple. The basic idea is that your monthly mortgage payment doesn't change regardless of what interest rates do. Sounds like a pretty good deal.

There's a massive problem though. If interest rates rise, as they have over this past year, the proportion of the fixed monthly payment that goes towards paying interest increases.

Until the mortgage essentially becomes interest only... 👇

Even worse, it turns out those fixed payments aren't actually fixed. Beyond a certain rate, the trigger rate is reached (the trigger rate is the point where the interest due is higher than the fixed payment amount) which opens up all sorts of depressing choices 👇

  • Some lenders will automatically increase the mortgage payment so that it continues to cover the interest portion of the payment.
    With this approach, if interest rates rise further in subsequent months, the payment will also need to increase to cover the larger interest payment (similar to a variable-rate mortgage with variable payments).
  • Other lenders allow for negative amortization, where the interest payment is permitted to exceed the total mortgage payment. Principal payments are therefore negative, so the balance owed on the mortgage increases from month to month.
  • Some lenders contact borrowers before they reach their trigger rate and offer options such as switching to a fixed-rate mortgage or making a lump-sum payment

None of those options sounds appealing. Imagine being told that your monthly payment is increasing purely so you can pay more interest! Or in the case of negative amortization, that your debt is increasing. All while house prices are falling. Depressing!

Why would anyone take out a fixed payment, variable rate mortgage?

In a world when interest rates are generally trending lower, it actually sounds like an amazing deal. You pay the same each month, and if rates fall further, you pay off the principal faster.

However, when interest rates hit rock-bottom in the pandemic, a simple, fixed rate was clearly a better choice, even without the benefit of hindsight.

Anyway, a load of these mortgages have already hit that trigger rate. That share will increase if mortgage rates keep rising too 👇

Depending exactly when these mortgages were issued (and the interest rate at the time), payments are set to increase by different amounts.

If a household re-mortgaged recently (when rates were low), the trigger rate was probably lower too, resulting in a larger increase in monthly payments as rates rise. Perhaps by as much as 20%...

A mortgage originated with a 30-year amortization period and an interest rate of 1.5% would have a corresponding trigger rate of 4.2% (at origination). In this case, we estimate that the monthly payment would have increased by about 20% by the end of October 2022.

The paper concludes that:

Households that took on a 30-year mortgage during the COVID‑19 pandemic when variable rates were extremely low will generally see a larger increase in mortgage payments.

If any financial entity issues misleading information that results in consumer hardship, there's usually a regulator to complain to. Maybe even get compensated.

Wonder if the same applies to central banks... 👇

“Our message to Canadians is that interest rates are very low and they’re going to be there for a long time”

The Bank of Canada say this will affect approximately 13 to 17% of all Canadian mortgages, and featured this graphic in their Financial Stability Review 👇

The data's a little stale (2021), but good to illustrate the high proportion of variable rate mortgages that were sold with a fixed payment option.

Although the graphic seems to suggest that the landlords only rent out non-mortgaged properties, which seems unlikely...

The rapid rise in Canadian home values was likely amplified by widespread mortgage fraud, so who knows what the real position of borrowers is?

It's common knowledge now that house prices will fall. The synchronised decline is well underway.  

This week, the RBNZ forecast a 20% peak to trough decline in New Zealand home values. Analysts expect a similar 17.5% drop for Canadian property prices.

Big risks hiding in plain sight. Will the BoC get away with just letting some air out of the Canadian housing market?