As the Bank of Canada continues its steady stream of interest rate cuts, many Canadians are eagerly anticipating a significant drop in mortgage rates across the board. However, economist Don Drummond, a former TD Bank chief economist and advisor to Canadian Prime Ministers, cautions that this expectation may not hold true for fixed-rate mortgages. This comprehensive analysis delves into Drummond’s insights, the current state of the Canadian economy, and what it all means for homeowners and prospective buyers.

The New Normal for Interest Rates

Speaking at the Mortgage Professionals Canada’s national conference, Drummond challenged the notion that rock-bottom interest rates are the “new normal.” He stated, “A lot of people, for a lot of years, said rock-bottom interest rates were the new normal. I never believed that. Obviously, it was a big shock when they went up.”

This perspective is crucial for understanding the current economic landscape. For over a decade, Canadians have become accustomed to historically low interest rates, which have shaped everything from personal borrowing habits to national housing market trends. Drummond’s assertion that this era was an aberration rather than a new standard is a wake-up call for many who have based their financial planning on the assumption of continued low rates.

Variable vs. Fixed-Rate Mortgages

While variable-rate mortgages closely follow the Bank of Canada’s overnight rate, which has decreased by 125 basis points since May, fixed-rate mortgages are influenced by bond yields. Drummond suggests that Canadians shouldn’t expect these yields to drop much further.

This distinction is critical for homeowners and potential buyers to understand:

1. Variable-Rate Mortgages: These are likely to see more immediate benefits from the Bank of Canada’s rate cuts, as they directly track the overnight rate.
2. Fixed-Rate Mortgages: These are more influenced by long-term economic outlooks and bond markets, which may not necessarily follow the same downward trajectory as the Bank of Canada’s policy rate.

The Future of Fixed Mortgage Rates

Drummond’s predictions for the future of fixed mortgage rates are particularly noteworthy. He forecasts that by next summer, we could see the overnight bank rate at 2.75%, with bond yields potentially higher than today’s 3.00% level. This scenario could effectively rule out any significant reductions in fixed mortgage rates.

“The new 5-year mortgage rate could be somewhere in 4.9% to 5%, not terribly different than it is today,” Drummond projected.

This prediction has several implications:

1. Limited Relief for Fixed-Rate Borrowers: Those hoping for a substantial decrease in fixed mortgage rates may need to adjust their expectations.
2. Potential Shift in Borrowing Preferences: We might see a shift towards variable-rate mortgages if the spread between fixed and variable rates widens significantly.
3. Impact on Housing Affordability: If fixed rates remain stable while property values continue to rise, it could further strain housing affordability in many Canadian markets.

Historical Context and Economic Impact

To fully appreciate Drummond’s perspective, it’s essential to consider the historical context he provides. Between 1996 and 2007, Canada’s inflation rate averaged right at the Bank of Canada’s 2% target. During this period, bond yields were stable, with the typical 10-year yield sitting 87 basis points above the bank rate.

This period of stability serves as a stark contrast to the volatility we’ve seen in recent years. It also provides a benchmark for what “normal” might look like in a well-functioning economy.

The Double-Edged Sword of Low Interest Rates

Drummond argues that the ultra-low interest rates from 2011 to 2019, intended as economic relief after the Financial Crisis, may have done more harm than good. These low rates contributed to skyrocketing house prices, paradoxically making homes less affordable even as mortgages became cheaper.

“You had a rock-bottom interest rate, but you had to buy a million-dollar house,” Drummond explained. “How does that help anybody?”

This observation highlights a critical issue in Canadian housing policy and monetary policy:

1. Short-Term Relief vs. Long-Term Consequences: While low rates provided immediate relief to some borrowers, they contributed to long-term structural issues in the housing market.
2. Wealth Inequality: The rapid appreciation of home values benefited existing homeowners but made it increasingly difficult for new entrants to enter the market.
3. Economic Distortions: Ultra-low rates may have encouraged overinvestment in real estate at the expense of other sectors of the economy.

Canada’s Broader Economic Challenges

Beyond mortgage rates, Drummond highlighted several broader economic concerns for Canada that have significant implications for the housing market and overall economic health:

1. Productivity Decline

Canada has fallen from 3rd to below 15th in productivity rankings among wealthy nations since 1960. This decline in productivity has far-reaching consequences:

• Wage Stagnation: Lower productivity growth often translates to slower wage growth, affecting Canadians’ ability to save for home purchases or manage mortgage payments.
• Economic Competitiveness: Reduced productivity can make Canada less attractive for international investment, potentially impacting job creation and economic growth.

2. Stagnant GDP Growth

Output-per-hour has increased by only 1% annually from 2000 to 2019, down from 3% in the 1960s. This slowdown in GDP growth has several implications:

• Government Revenue: Slower economic growth can lead to reduced government revenues, potentially limiting public investments in housing and infrastructure.
• Consumer Confidence: Persistent slow growth can dampen consumer confidence, affecting spending habits and housing market dynamics.

3. Weak Business Investment

Drummond pointed out particularly weak investment in software, machinery, and equipment. This underinvestment can have cascading effects:

• Job Creation: Reduced business investment often leads to slower job creation, affecting Canadians’ ability to enter the housing market.
• Innovation: Lack of investment in new technologies can hinder productivity growth, creating a cycle of economic underperformance.

4. Low R&D Spending

Canada’s private sector ranks among the lowest globally in research and development efforts. This lack of R&D investment can impact the economy in several ways:

• Future Competitiveness: Reduced R&D can limit Canada’s ability to compete in high-value industries, potentially affecting long-term economic prospects.
• Brain Drain: Lack of R&D opportunities may lead to talented Canadians seeking opportunities abroad, impacting the domestic talent pool.

Immigration and Housing: A Delicate Balance

Drummond also touched on the recent changes to Canada’s immigration targets, providing valuable insights into the complex relationship between immigration policy and housing market dynamics.

Recent Policy Changes

Despite a reduction from the initial goal of 500,000 new permanent residents by 2025 to 395,000, Drummond noted that this figure still far exceeds the annual housing supply growth of 250,000 units. This mismatch between population growth and housing supply has several implications:

1. Housing Shortage: The continued influx of new residents without a corresponding increase in housing supply is likely to exacerbate existing shortages.
2. Price Pressures: Increased demand for limited housing stock could continue to drive up prices in many markets.
3. Regional Disparities: The impact of immigration on housing markets is likely to be unevenly distributed, with major urban centers feeling the most pressure.

Economic Implications of Immigration

Drummond suggested that reduced immigration numbers could benefit both immigrants and native-born Canadians, citing challenges faced by recent arrivals in wage growth and employment. This perspective raises several important points:

1. Labour Market Integration: The ability of the Canadian economy to effectively integrate new arrivals into the workforce is crucial for overall economic health.
2. Social Services Strain: Rapid population growth without corresponding economic growth can put pressure on social services and infrastructure.
3. Long-Term Economic Growth: While immigration is often seen as a driver of economic growth, Drummond’s comments suggest that the relationship may be more complex than commonly assumed.

Looking Ahead: Navigating Uncertain Waters

As Canada navigates these economic challenges, Drummond’s insights serve as a reminder that the mortgage and housing markets are complex systems influenced by numerous factors. While the Bank of Canada’s rate cuts may provide some relief, particularly for variable-rate mortgage holders, those with or considering fixed-rate mortgages should temper their expectations for significant rate reductions in the near future.

Strategies for Homeowners and Buyers

Given the current economic landscape, here are some strategies that Canadians might consider:

1. Stress Test Your Finances: Even if rates don’t rise significantly, ensure you can handle potential increases in your mortgage payments.
2. Consider Hybrid Mortgages: A combination of fixed and variable rates might provide a balance of stability and potential savings.
3. Focus on Paying Down Principal: With rates potentially remaining stable, focusing on reducing your principal can provide long-term benefits.
4. Stay Informed: Keep abreast of economic indicators and policy changes that might affect the housing market.
5. Think Long-Term: When making housing decisions, consider long-term economic trends rather than short-term fluctuations.

Policy Considerations

Drummond’s analysis also raises several important policy considerations:

1. Housing Supply: Addressing the mismatch between population growth and housing supply should be a priority for policymakers at all levels of government.
2. Productivity Enhancement: Policies aimed at boosting Canada’s productivity could have positive knock-on effects for the housing market and overall economic health.
3. Balanced Immigration: Ensuring that immigration levels are in line with the country’s ability to provide housing and economic opportunities is crucial.
4. Investment Incentives: Encouraging business investment, particularly in R&D and productivity-enhancing technologies, could help address some of the underlying economic challenges Drummond identified.

Conclusion

As Canada faces a complex economic landscape, characterized by changing interest rates, productivity challenges, and demographic shifts, the insights provided by experts like Don Drummond are invaluable. For potential homebuyers and current homeowners alike, staying informed about these economic trends and seeking professional advice will be crucial in making sound financial decisions in the coming months and years.

The interplay between mortgage rates, housing affordability, immigration, and broader economic indicators underscores the need for a holistic approach to economic policy and personal financial planning. As we move forward, the ability to adapt to changing economic realities while maintaining a long-term perspective will be key to navigating the Canadian housing market successfully.

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