Love Thy Neighbo(u)r

Canada and the United States share a long and storied past. The 2 countries, while vastly different on many fronts, are also very similar in many aspects. We share the longest unprotected border in the world, allow the free passage of each others citizens, and were founded on many of the same democratic and capitalistic processes.

I have stopped counting the number of times I have been told recently that ” The BOC must raise raise based on the US Fed, or else the Canadian dollar will go into free fall”. I have been told this so many times in fact, that if I had a dollar for every time I heard it, I could probably pay off all the mortgage debt in Canada! Lets for a minute ignore the fact that the statement is incorrect, and also lets ignore the fact that a falling Canadian dollar would help the economy. Lets in fact focus on the statement.

While throughout much of recent history, the Canadian BOC and the US Federal reserve have maintained a close relationship on rates, it is not required, nor perhaps even desired. The general thesis came from the close economic ties that the 2 countries share. Over the last 30 years we have witnessed a global “offshoring” of productivity, and as such, the Canadian and US economies have moved closer together, and ” tied at the hip” if you will. However, the BOC does not have a mandate to control the price of the Canadian currency. The ONLY mandate the BOC has is to control the level of inflation between 1% and 3% with an aim of 2%. That is it, that is all. The official mandate of the BOC has nothing to do directly with house prices, the Canadian exchange rate, nor maintaining a peg to the US Federal Reserve. Now, of course, everything in some way shape or form CAN affect inflation, but it is simply an aftershock rather than a desired input. For example, if the price of a loaf of bread went crazy ( even though the BOC does not have a mandate to control the price of a loaf of bread ) it could lead to inflation trending up, which could cause the BOC to raise interest rates to cool demand. However, this is a lot different than saying the BOC fixes bread prices – that can only be done by Galen Weston and the other large grocery giants!!

In the not too distant future, I think there could be a deviation coming in the BOC and the Federal Reserve monetary policy. While this would be a negative for the Canadian dollar, I think it is unavoidable. While the 2 countries share many things in common, one very big difference is the way mortgages, and debt in general work between the North and South side of the 49th parallel.

As we are all aware, Canada, for the most part, has 5 year mortgage terms. This means – very simply, that every 5 years you must renew your mortgage at the current prevailing interest rate. Economists, bankers, brokers, and media pundits are already predicting the “cliff” or “wave” of upcoming renewals. Brokers are already starting to see clients forced to renew from the 1.89% range to the current 6.34% range. It doesn’t take a PhD in finance to recognize the large jump up in payments could, and most likely will cause a massive problem for the average household budget. The average person simply cannot afford a 200% increase, in what is already likely to be their largest monthly obligation.

Contrast this to the United States where it is typical to lock in to a 30 year fixed rate. The average American debtor has 30 years of low rate protection, of which almost 28 years remain. This means that the average mortgage holder in the US will enjoy and benefit from a rate, quite likely below 2.75% for 3 decades to come. They simply will not be subject to a large increase in expenses, like their Canadian counterpart. The difference in monthly disposable income over 3 decades is sure to make a substantial difference in economic spending, inflation, and levels of rates.

High debt levels in Canada have been a growing worry for sometime. However, no matter how bad, every problem needs a catalyst. High debt levels – at affordable rates, are manageable, as we have seen for 5 or so years. High debt levels with interest rates at 25 year highs?? Not so much. The mortgage renewing at levels ( interest rates ) not seen by anyone under 45 will be the catalyst that could lead to a long bumpy economic road ahead for a lot of Canadians. Just to add insult to injury, Canada has some of the highest prices of real estate in the world. So add up very high prices with very high rates = very high payments.

This divergence in the US and Canadian economy could easily cause the BOC and the Federal Reserve to start taking a different path when it comes to rate setting, and policy. While the US will certainly face some recessionary issues, I do not think it will be even close to the outright deflationary issues that will affect the Canadian economy once we start to see the full wave of mortgage renewals coming in. Based on he very limited samples we are seeing now, the public renewing at much higher rates is going to be a problem.