Author: CIBC World Markets - Benjamin Tal
Article Date: May 25, 2007
Things are getting a bit complicated. The Bank of Canada is facing a difficult dilemma. Inflation is a bit higher than expected, the economy is doing OK (not great) and the dollar is very strong. At the same time, the US economy is clearly slowing, and the housing market there has not reached bottom yet. So what make sense at this point? The recent increase in long-term interest rates in Canada reflects growing market expectations that the Bank of Canada will raise rates by 50 basis points by the end of the year. What will determine if the market is right will really depend on developments in the US. And there are clear signs that the difficulties in the housing market south of the border will continue in the second half of the year. Inflation has reached its peak, and with the softening rental market, prices will probably start softening in the coming months. So, the focus should be on the extent to which this slowing is significant enough to trigger a rate cut by the Fed. If yes, then the Bank of Canada will not dare raising rates in an environment of falling US rates. Such a situation will take the Canadian dollar to the sky with major negative consequences to the economy. Therefore, we have to ask ourselves two questions: - Will the Fed cut rates?- Will the strong dollar prevent the Bank of Canada from raising rates?As for the Fed, our call is that the softening in the US economy and the downward trend in inflation will lead to a rate cut by year end. Admittedly, we give this scenario only 55%-60% probability. In such a situation, we expect the Canadian dollar to continue to appreciate during the coming six months — a situation that will prevent the Bank of Canada from raising rates. Note that under this scenario, we probably will see long-term rates falling by year end, since the bond market will not get what it is currently discounting (a rate hike by the Bank). Within the next six months, expect a lot of volatility in the market — with the five year rate possibly rising even higher as investors try to make sense of the economic news. But by the end of the year, we believe that the market will realize that inflation is trending downward and the strong dollar is hurting the economy — a situation that will lead to some decline in the five year rate. So, what to do? There is about 55%-60% probability that the five year rate will be somewhat lower by December 2007 than it is now (since the market is probably overshooting now) and the prime rate will be roughly the same. Thus, waiting until the end of the year before locking is an OK strategy. But as readers can already detect, the level of uncertainty at this point is very high, and there is a 40%-45% probability that the Fed will not cut rates, and hence the Bank of Canada will raise rates and the five year rate will not go down. So for more conservative borrowers, locking now will probably be a reasonable and a relatively safe choice.
View The Entire Article: Mortgage Rates: What To Do?
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