How the Brexit Affects Canadian Mortgage Rates

Well, that was unexpected.

Last Friday, voters in the United Kingdom surprised markets when a small majority voted in favour of leaving the European Union (EU). While the polls showed a tight race between the Leave and Remain sides, markets were giving about 70% odds to the Remain side pulling through. History has shown that on votes like this, with Scotland’s referendum on independence the most recent example, momentum tends to swing in favour of the status quo at the last minute when voters stand in the voting booth and face their moment of truth. While the Remain side did appear to gain some last-minute momentum, this time, it was too little, too late.

Here are five key observations relating to the Brexit, followed by my take on what last Friday’s vote result will mean for our mortgage rates:

1. The Brexit may well break up the UK along with the EU – Scotland’s independence vote (on whether to leave the UK) had a closer margin than its Brexit vote: 55% of Scots voted to stay in the UK two years ago and 62% voted to stay in the EU. With Brexit, they can no longer do both, and Scotland’s leaders have already announced plans for another referendum which asks its citizens to choose between the two. Northern Ireland also voted to remain in the EU, with 56% in favour of Remain. Could Brexit lead to the reuniting of Ireland? Is anyone betting against that outcome at this point? It will be interesting to hear the leaders who supported the UK’s exit from the EU try to make the other side of the Remain/Leave argument to voters in both countries when (Scotland) and if (Ireland) the time comes.
2. The Brexit will lead to the creation of a new EU financial centre – Until now, London has been the financial services centre for the EU as well as the UK, but when the UK leaves the union, a new EU financial centre will evolve. While the EU is expected to form free-trade agreements covering most goods and services with the UK in the post-Brexit environment, the EU has not historically granted non-EU members unfettered access to its financial markets. As a result, London’s access to EU financial markets could be seriously affected, and this would deal a big blow to the British economy, where financial services account for about 10% of its national GDP. (My money is on Dublin, a sophisticated, well-educated English-speaking centre in the same time zone as London, neatly positioned between North American and Asian markets and with a very favourable tax regime for businesses.) A German city might also emerge as an option, but I wonder whether the EU’s members would be comfortable allowing Germany to consolidate even more economic power within its borders.
3. The Brexit is likely to lead to more referendums in Europe – The Brexit was, in part, a repudiation of life under a supranational, remote, largely nameless and faceless government, and interestingly, that repudiation came from the one country in the EU that wasn’t constrained by its heaviest yoke, the Euro. There is anti-EU sentiment in many of the other member countries, and the Brexit is likely to stir up nationalist fervour across the region. It’s not clear that the Brexit will inspire full exits by other countries, but make no mistake, this represents a shifting of economic tectonic plates and the Brexit’s impacts will likely lead to changes in the EU’s governing culture. I see a future where the populations of EU countries demand votes on immigration policies, bail-out agreements, budget parameters and, from time-to-time, a stay/go decision.
4. The EU’s handling of the Brexit will depend, in part, on the reaction of financial markets – The EU’s leaders are conflicted about how to handle the Brexit. If the Brexit is unpleasant and costly for the UK, it will serve as a warning to other EU countries who are contemplating their own exits. But the UK’s pain will be shared across the English Channel and the EU can’t really afford to risk too much of its own fragile economic momentum just to make an example of Britain. The EU will have to walk a bit of a tightrope with markets as it hammers out new agreements with the UK.
5. The Brexit vote provides the latest confirmation that populist, isolationist sentiment is on the rise – Populists tend to do well in times like this, when economic growth is slow and when unemployment and under-employment are well above their long-term averages. I believe the Brexit vote is fruit from the same tree that has led to the rise of Donald Trump and is fuelling the powerful resurgence of right-wing nationalist parties in many developed countries. Not that it matters to those who shout the loudest, but the reduction in global trade has been the main drag on recent global economic growth, and if countries turn away from open markets, global economic growth will slow even more, and in so doing, will further exacerbate populist sentiment as part of a self-reinforcing cycle.

In answer to the first question on almost everyone’s mind, I don’t believe that the Brexit-related volatility will lead to a repeat of anything like the 2008 financial crisis. The systemic shock from the Lehman Brothers collapse in 2008 was magnified in part because it was a completely unforeseen event that caught markets off guard. While Friday’s outcome was unexpected, everyone had time to see the Brexit vote coming and to think about its possible impacts. And thanks in part to the lessons learned from 2008, the global financial system was better prepared this time around. (For example, corporate banks are better capitalized and central banks have more robust liquidity backstops in place.) This is why Friday’s initial market reactions gyrated within the bounds of what would be considered normal volatility.

Here is a quick summary of how I think the initial Brexit impact will affect our mortgage rates in the near future:

Fixed-Rate Mortgages

I don’t think last Friday’s vote will have much short-term impact on today’s fixed rates. When events like this happen, there is typically a flight-to-safety where investors pile in to safe-haven assets like Government of Canada (GoC) bonds, which our fixed mortgage rates are priced on. But when the dust settled on Friday afternoon, the five-year GoC bond yield was only up four basis points for the week, which is hardly noteworthy, and while the vote result was a surprise to markets, the ensuing volatility it created was largely contained (unless you happen to own a lot of British pounds).

Even if GoC bond yields were to fall precipitously going forward, it is unlikely that our lenders will respond with any immediate rate cuts. Using the 2008 financial crisis as an example, when GoC bond yields plummeted, our lenders held rates steady, citing their reluctance to respond to heightened volatility with knee-jerk reactions (and enjoying fatter short-term profit margins as a reward for their prudence).

Variable-Rate Mortgages

I think the Brexit result pushes out the timing of when the U.S. Federal Reserve will next raise its policy rate. Fed Chair Yellen had already cited “uncertainty” as a central theme in the Fed’s current global economic view, and I don’t see the Fed contemplating rate hikes now, at least until the Brexit’s impacts are more clearly understood.

(Reminder: Canadian variable-rate borrowers should pay attention to what the Fed says because the U.S. and Canadian economies are deeply linked and Canadian monetary policy tends to move in the same direction as U.S. monetary policy over the longer term. Over the near term, Bank of Canada (BoC) Governor Poloz has made it clear that the BoC expects to lag the Fed’s timing for raises during the current cycle, so in the current context, the Fed’s evolving economic view gives us a kind of distant-early-warning signal for the timing of the BoC’s next rate hike – distant as that prospect still seems.)

Five-year GoC bond yields rose four basis points last week, closing at 0.63% on Friday. Five-year fixed-rate mortgages are available in the 2.39% to 2.49% range, depending on the terms and conditions that are important to you, and five-year fixed-rate pre-approvals are offered at around 2.54%.

Five-year variable-rate mortgages are available in the prime minus 0.40% to prime minus 0.50% range, which translates into rates of 2.20% to 2.30% using today’s prime rate of 2.70%.

The Bottom Line: The UK’s decision to leave the EU should not have a significant short-term impact on Canadian mortgage rates. Over the longer term, while the Brexit heightens global financial risks and raises the potential for increased volatility in financial markets, any related flare ups should trigger a capital flight to safety that would be expected to put downward pressure on our bond yields and therefore our mortgage rates. Nonetheless, we should resist the urge to celebrate because the same Brexit-related volatility that helps keep a lid on our future borrowing costs might also weaken the incomes we need to pay them. Stay tuned.