Why Investors Should Not Fear Rising Interest Rates with David Larock

Speaker 1: Welcome to the True Condos Podcast with Andrew la Fleur, the place to get the truth on the Toronto condo market and condo investing in Toronto.

Andrew la Fleur: Okay. It’s my pleasure to welcome to the show for the first time David Larock. David is a mortgage broker with Integrated Mortgage Planners. David, welcome to the show.

David Larock: Thanks, Andrew.

Andrew la Fleur: Yeah, great to have you here. I know we’ve met here and there over the years, and I’ve read a lot of your blogs and stuff over the years. I think you’ve been blogging almost as long as me, or maybe even more, which is amazing. How long have you been in the mortgage business, and how long have you had your blog and stuff?

David Larock: Well, I’ve been in the mortgage business for almost 20 years. I spent the better part of the first decade in lending. I worked for three different lenders and then moved over to brokering about eight years ago, and I’ve been blogging since then. I’ve been a blogger for eight years. How about for you?

Andrew la Fleur: Eight years? Yeah, I’ve been, maybe a little bit longer, about nine or 10 years, so you’re right on my tail.

David Larock: [inaudible 00:01:04].

Andrew la Fleur: But I love it. It’s always great to see somebody who’s been putting out great content for a long time. It’s obviously a big part of what I do and what I believe in. So many people just don’t have the stamina and they just can’t stick around, but it’s great to see that consistency. You’ve been pumping it out for a long time, so keep it up.

David Larock: Thanks.

Andrew la Fleur: Yeah. Of course, a lot of people can read your stuff on your website, but also on movesmartly.com as well, which is a great site. Let’s jump right into the big topic of the day right now and the reason I wanted to get you on. I talked about it in a recent video I did, which was your analysis of the interest rate situation right now in the Bank of Canada. You had a great article, sort of tackling that and basically talking about you’re … or at least how I read it was you’re somewhat skeptical of the interest rate increases, whereas most of the narrative and the discourse in the media and in the public on street, so to speak, is, “Well, here it is, guys. Interest rates are finally going up, and they’re going to go up, and they’re going to keep going up. The days of cheap money are over, and the next sort of line of thinking is the sky is falling and it’s all going to come to a halt,” this kind of thing.

But your perspective obviously is a little different. You take a much more measured approach to analyzing the situation, so let’s hear what you have to say. What’s the deal with Bank of Canada raising interest rates right now, why are you skeptical about it, and where do you see things going?

David Larock: Sure. Well, the Bank of Canada wants to raise rates. They’ve made that clear for a long time. The only problem is the economy hasn’t been cooperating with them. To be clear, I think … I mean, if they want to, they clearly can. The question is will they continue to raise rates, and if so, by how much? Where I differ from the consensus view today … I have to warn you, I’m a contrarian by nature, so I do tend to scratch my contrarian itch on a regular basis, especially when it comes to interest rates over the last eight years. Where I differ from the consensus view today is that I don’t think rates are going sharply higher. I think we’re going to see very gradual increases.

I think the Bank of Canada is going to have no choice but to take a wait-and-see approach. The more they raise, the more I think the odds are that rate cuts might also be in our future, and that’s based on several things. Number one, the Bank of Canada’s main mandate, their primary mandate on page one of every monetary policy report they issue, says that their main job is to promote price stability, and that is by controlling inflation. So, basically, if inflation is at 10%, that’s bad for the economy, it leads to all kinds of distortions, and we determined that a target rate of 2% inflation is what would be considered healthy.

It’s just enough to keep people buying today because prices are going up slowly over time. It’s not high to the point where it destabilizes the economy, but it’s also not zero, because when it’s zero we could end up in a deflationary environment and that scares the Bank of Canada. That’s what keeps financial bankers up at night because their monetary policy tools are much better suited towards reining inflation in than trying to pull back deflation. The tools don’t work nearly as well when it comes to controlling deflation. As we’ve seen with the Bank of Japan trying to reverse deflation there for two decades, they’ve had a very difficult time.

Basically, when I’m skeptical about whether or not rates are going sharply higher today, the first thing I look at is inflation. We just got the inflation stats for June today and, unfortunately, it’s now dropped to 1%. That’s the lowest it’s been in almost 20 years. So if the bank’s primary mandate is to control inflation, and if they have an inflation target of 2%, and if inflation has been below 2% for 63 consecutive months … Sorry, core inflation, which strips out the most volatile factors in overall inflation.

Core inflation is basically a subset of overall inflation, but it’s seen as a bit more of a stable number that doesn’t bounce around as much because things like food and energy prices, which are quite volatile, are stripped out of core inflation. Core inflation in Canada has been below the Bank of Canada’s 2% target for 63 straight months and overall inflation just came in at 1%. If you were to look at our inflation stats, you might say, “Why is the Bank of Canada raising at all?” The Bank of Canada should be cutting because the Bank of Canada also says, “Our goal … We are just as concerned with inflation being below target as we are with inflation being above target.” If they held true to that belief, then they should be cutting, not raising.

Now, anybody who reads my blog or, quite frankly, anybody who’s been watching and reading about what’s happening with interest rates will know that the period of ultra-low interest rates that’s gone on now since the start of the Great Recession in 2008 has created distortions. What happens when rates are really low is, for example, pension funds and insurance companies that need to invest in long-term bonds, they’re very restricted in what they can buy, they’re not getting any kind of yield, any kind of return on their investments. The yields are too low to meet their long-term obligations.

The same thing happens with individual savers and pensioners. If they can’t make money investing safely … And they need to make money to live. If you’re a pensioner, you’ve got to live off of the returns you make off of your investments. Well, if that’s a big part of your income, then what happens is people start what’s called chasing yield. They start taking on more risk to try to replace that lost yield. And that’s disturbing because if people, if pensioners, are investing in risky stuff to get the yield they need to create the income that they need to live on, then over time they’re not investing appropriately, and then those riskier assets perform as riskier assets, those borrowers take losses, and that’s destabilizing because they can’t afford to take on the losses.

One of the things that the Bank of Canada is concerned about is the negative effects that ultra-low rates have had on our economy. The other concern is asset bubbles. Whether or not we’re in a bubble is a hot source of debate, but there’s no question that as rates have fallen, house prices have increased. Well, if you looked at a graph you’d see rates going from the top left corner down to the bottom right corner, and you’d see house prices going from the bottom left corner up to the top right corner. Now, I won’t get into my view in detail on house prices, but there’s also an argument that Canadian house prices are finally getting their due. There’s no debate that falling interest rates have helped push house prices higher. That concerns the Bank of Canada.

The other thing that concerns the Bank of Canada about ultra-low interest rates is that household debt levels are now quite elevated. Even though the cost to service that debt is low today because rates are quite low, if rates go higher the cost to service that debt will increase and that would put some borrowers under stress. There are other reasons, but those are the key ones. For those reasons, the Bank of Canada and central banks around the world are nervous about keeping rates at ultra-low levels indefinitely because it creates these distortions. It risks destabilizing the economy.

The challenge the Bank of Canada has is, as I said initially, there is virtually no inflation right now. The other challenge they’ve got is that when they raise rates, the Canadian dollar goes up. Yes, our economy is finally doing better, and it’s doing better in large part because our exports are booming. We’re doing much better with our exports than we’ve done in years and years. If you remember, after the financial crisis started, the loonie actually was worth more than the greenback and our exporters got hammered. In fact, a lot of them went out of business, and it took years for our export manufacturing sector to recover.

The export manufacturing sector is critical for a small open economy like ours because those jobs create other jobs in the economy. The average manufacturing job in Canada creates about 2.7 other unrelated jobs in other parts of the economy because it creates demand that then feeds into those other parts of the economy indirectly. These are key jobs. The export manufacturing sector is critical to any … Basically, what the Bank of Canada has said repeatedly, both Governor Carney and Governor Poloz have said, is that any long-term healthy economic recovery that we have has to be underpinned by improving in stronger export manufacturing sector.

Well, when the Bank of Canada raised rates, the loonie was at 76 cents, and today it’s at 80 cents. That may not sound like a big difference, but to our export market that’s a big difference. Remember, we have to compete with other countries who also export to the U.S. For example, when you look at the Canadian dollar versus the peso, the Canadian dollar fell against the peso in the first six months of this year. It’s now gone up quite sharply against the peso since the Bank of Canada raised rates.

As the Bank of Canada raises rates in a non-inflationary environment, it causes the loonie to head higher and undermines, creates a headwind, for our export sector. Whereas our export sector was benefiting from a cheap loonie and that created the kind of momentum that made the Bank of Canada believe that it was safe enough to start raising rates, as soon as they do that, the loonie goes up in value, what was a tailwind for our export sector becomes a headwind, and it is a self-reinforcing act. So basically, the more we raise, the more strain we put on the parts of the economy that were doing well enough to give them the confidence to raise.

The other thing the Bank of Canada has acknowledged repeatedly is that with household debt levels where they are at now, they don’t have to raise by as much to slow the economy. When there’s not a lot of debt, the Bank of Canada has to increase its rates a lot to slow inflation, and we can all sort of wink when we say that because there’s really no inflation to slow at this point, but that’s the theory. The Bank of Canada has said, “If we’re worried about inflationary pressures, with household debt levels this high, we shouldn’t have to raise by nearly the extent that we would have in the past to slow the economy back to the desired level.” They’re saying, A, we don’t have to raise by as much as we’ve historically had to raise by, and they call that … The way they capture that number, for how much they think they have to raise by to bring the economy back in the balance, it is called the neutral rate.

What the neutral rate means is it’s the rate that the Bank of Canada has, which if they set the overnight rate, their policy rate, at the neutral rate, it is not as stimulative, nor … Sorry. Let me put it another way. It’s neither a headwind nor a tailwind for our economy. It’s a neutral rate. They’ve been dropping the neutral rate for years now. They’ve been lowering it, and that is an acknowledgement that the rate that they see long-term that our economy will need is lower than it has been historically.

All of those factors feed into my view that even though the Bank of Canada is raising its rate, A, it will be difficult for them to raise by much more and they’re going to have to take a wait-and-see attitude, and B, when they do ultimately feel confident enough to raise, the extent to which they raise will be diminished by household debt levels and other factors like aging demographics, you name it.

The bottom line is those who are saying rates are going much higher, I think need to dig into the details because, yes, that’s what the headlines say but there’s a whole lot of evidence, which I’ve touched on briefly here. Again, I write a thousand-word blog every week that goes into a lot of detail. I can’t possibly capture it all here, but there’s a whole lot of evidence, and the experts that I read point to a lot of the time, to counteract this sort of screaming headline that the end is nigh, the wolf is at the door, rates are going sharply higher, this is the end of everything. I do take a rather cynical view of those headlines.

Andrew la Fleur: Wow. David, that’s amazing. You dropped some amazing knowledge on us there in terms of what’s happening and why you’re skeptical of the Bank of Canada’s sort of hawkish tone they’ve taken lately. I want to transition us to more practical terms the people on the street, real estate buyers, and a lot of investors, especially real estate investors, listening to this show because a lot of people that I’ve talked to lately … well, not maybe a lot, but a significant number of people at least … have sort of taken the wait-and-see approach.

Some people are, I don’t know if you want to call it fearful or just concerned, that interest rates are going to continue to go up, the cost of getting a mortgage is going to continue to go up, and that’s going to basically mean that real estate prices are going to go down, is sort of the line of thinking. So they’re just taking a wait-and-see approach to see if that happens, and say, “I don’t want to buy today because, look, interest rates are definitely going up. I see the headlines everywhere. Interest rates are going up, so I should not buy today. I should buy tomorrow because real estate prices are going down.” I know you’ve got some amazing thoughts on that aspect so I’d love to hear what you have to say about that thinking.

David Larock: Well, it’s interesting because if real estate prices are going to go down in the future because rates are going to go up, then I’m not sure you’ll be better off. If prices fall but rates go up, that means your cost to borrow increases and the price to buy goes down, but if rates go to 10% and prices don’t fall to the same extent, you would have been better off buying today. Basically, the fact that prices fall means that the cost of the asset gets cheaper, but the cost to borrow to pay for the asset goes up, so those two things may well offset. In fact, there’s no guarantee that one force will be stronger than the other. To me, you’d have to have some very strong views about where rates were headed and the effect that it would have on house prices, and that’s really throwing a dart at a board. I mean, I don’t think anybody can reliably make that prediction, although people may think they can.

I mean, the bottom line is, Andrew, there are reasons to be nervous today if you’re a buyer. I think the nervousness about higher interest rates are overblown, but there are other things that are uncertain at this point. For example, the Ontario government has introduced those measures to try to slow the rate of house price appreciation in major markets. We’ve got the foreign home buyers tax. We’ve got mortgage rule changes. We’ve had five rounds now. OSFI is making noise, so maybe a sixth round of changes. And prices have gone up quite significantly, especially in the Toronto area, by a lot.

I understand why people are nervous today, but when people are nervous because they’re worried about interest rates going sharply higher, I don’t think that should be very high on the worry list. I think if that is their main worry, I think that that worry will ultimately prove to be unfounded. Now I should add, because I’m stating some strong opinions here, my opinion and a buck fifty will get you a cup of coffee. I don’t have any claim over what will happen in the future. I certainly spend a lot of time researching this and writing about it, and I feel confident in my views, but rate predictions don’t come with guarantees.

Andrew la Fleur: I wanted you to touch on one of the articles you’ve written, which was, I believe, headlined, “Do rising interest rates lead to lower real estate prices specifically?” What’s the key point of that article that you wrote about that?

David Larock: Well, that article amazingly was written back in 2010. It’s called, “Do higher interest rates cause lower house prices?” And suddenly new interest in that article has gone through the roof. There’s over a hundred people a day clicking on that article now. Basically, what it does is it takes a look back at what happened to house prices immediately following rate increases in the past. I basically took some data and it’s all detailed in the post, but what I found was that immediately after rate increases, the demand for real estate increases. It doesn’t fall. You could argue there are lots of reasons for that. Maybe it’s because people think there’ll be more increases so they should get into the market in the meantime.

Basically, what the article goes on to say is that typically when the rates rise, it’s because the economy is doing better. In this case, the Bank of Canada today thinks the economy is doing better, and that’s why they’re raising rates. So the fact that rates are rising is a positive sign to the economy. Usually, in the vast majority of cases incomes are rising, the economy is doing better. There are lots of positive things that are causing rates to rise. Rates rising themselves is not a good thing if you’re a borrower because you’re in the market for a mortgage, but that same borrower is probably benefiting from a stronger economy. That’s the point that I make in the post, that even though rates are rising, if rising under normal circumstances and the economy is strengthening, then the strengthening of the economy has a greater overall impact on a borrower’s ability to pay and on house prices than the fact that the cost of borrowing is rising.

Andrew la Fleur: Very interesting point, yeah, and it’s obviously contrary to what, again, people on the street are sort of thinking or are led to believe by the headlines that are out there. David, I really appreciate your time today. One other question I wanted to get your take on as we’re chatting here today is, as you alluded to, potentially some pretty big, new changes coming from OSFI, which will affect all mortgage borrowers in Canada. Can you tell us what those are, and how you think they could affect the market if they’re brought in?

David Larock: Sure. Well basically, a few years ago, our regulators introduced the mortgage stress testing. Basically, what they said is if you are a high ratio borrower, so if you’re putting down less than 20% of the purchase price of the property, you have to qualify when you apply for a mortgage as if your interest rate was 4.64%, and even though your rate will be probably about half that, in reality, you have to qualify and show that you can afford for the rate to be 4.64%.

They did that because, well, number one, in the U.S. a lot of people were qualified for mortgages based on teaser rates for 30-year term mortgages with a one-year teaser rate. They were qualified using their one-year teaser rate, and then after the end of the first year, when the teaser rate tripled, they couldn’t qualify and the only way that they were able to continue to make payments is they refinanced the loan for a new 30-year term and got a new one-year teaser rate.

Eventually, of course, that all blew up and we all know what happened to the U.S. housing market. Our regulators looked at it and said, “What can we learn from Big Brother down in the U.S.?” They said, “We need to create a test for our most vulnerable borrowers,” which they determined are people who are putting down less than 20% because they have the least amount of equity in a property, “And what we’re going to do is we’re going to make sure that they can afford, when they come to renewal, for rates to be higher.”

Originally they said, “Okay, we’re going to use this test for all borrowers who are putting down less than 20%. We’re also going to use this test for people who want a variable-rate mortgage, because even though those rates are quite low, they could go higher, so we want to make sure that those borrowers have the ability to afford higher rates, and we also want to make sure that if you have a fixed-rate mortgage of less than five years, because if you have a one- or a two-year mortgage you’re going to have to renew fairly quickly as well, we want to make sure that those borrowers can qualify using this stress test.”

Over time, what’s happened is the stress test has captured a larger and larger percentage of the market. But while this was happening, the whole time this was happening, borrowers who wanted a five-year fixed-rate mortgage, who were putting down 20% or more of the purchase price of the property, conventional borrowers as they’re called, were allowed to qualify using the contract rate of the mortgage, which today is still under 3%, and that’s most borrowers. I mean, in reality, most buyers have 20% or more, and most Canadians did five-year fixed-rate, so while this stress test was affecting people at the margin, where our regulators determined the most risk was, the sweet spot, the center of the market, conventional buyers, so again, people putting down 20% or more who wanted a five-year fixed-rate term, those borrowers were still allowed to qualify at the contract rate.

The next change that OSFI has now proposed is that those borrowers, along with everyone else, so basically all borrowers, should have to qualify at the rate of 4.64%. Now, I have all kinds of problems with this. I had been in favor of all of the mortgage rule changing to date because I thought that they were needed and that ultimately, we have some short-term pain for some long-term gain, but that anybody who was willing to accept that prices can go up by 30% a year would realize that these were prudent changes even if they created some short-term disruption.

My concern with the mortgage qualifying rate today at 4.64%, and I’ll refer back to the first answer I gave you on where rates are headed, the 4.64% number isn’t a statistical calculation. They haven’t really put a lot of rigor into coming up with that number. They’ve basically taken the posted rates at the six largest banks in Canada and averaged them. And those posted rates, by the way, aren’t the rates that those banks lend at. The only reason those rates exist, as far as I can tell after 20 years in the business, is they are what the banks use to calculate mortgage penalties, and that’s the reason bank penalties are five times higher than the non-bank lenders charge, because they have these ridiculous inflated posted rates.

To me, using those rates as a stress test, there’s not a lot of science behind it. If the Bank of Canada would like to make the case that five years from now rates are going to be at 4.64%, mortgage rates are going to be at 4.64%, which would be a new doubling from where they are today, I would like to hear that case. I mean, first of all, it would run counter to just about everything I’ve read than, say, in the last many years. Second of all, I think a lot of smart people could come up with a lot of strong counterarguments for anything that the Bank of Canada put out there. And thirdly, if they can’t make that argument, why are we using this number?

Number one, we’re giving the big six banks control over setting that rate, because when they move their posted rates that changes the stress test rate. But more importantly, if there isn’t really a whole lot of logic, and I haven’t seen the logic for how that number is set, is that really a true stress test? Are we really qualifying borrowers based on a reasonable and conservative view of what the future will look like or are we just sort of saying, “Well …”

I mean, using a market rate makes sense to me, but let’s use a rate that people are actually lending at on a daily basis and then gross it up. If they said the rate should be an average of the big six banks’ actual five-year fixed lending rates, the ones they lend at on a regular basis plus 2%? Fine. Then, at least, we should have a discussion about whether or not that’s the right number, but when it’s opaque like this and we’re just using bank posted rates, well, at that point it’s hard to really know the logic that went into it.

Back to your original question, this change by OSFI, it sounds like a smaller change because it’s only conventional borrowers, and it’s only on five-year fixed rates, but because that is most of the market, it is a big change and it will have a significant impact. My hope is that OSFI, when it sees what’s happening in the market, that the Toronto market is flowing, when they see that interest rates have already risen, when the mortgage rule changes that were made last fall continue to bite, that they’ll take more of a wait-and-see approach. But if they do make this change, it will be significant and somewhat concerning.

Andrew la Fleur: Yeah. In summary, somewhat concerning, yeah. No, that’s a great explanation, David. I really appreciate the background. Just numbers-wise, because they’re basically applying a rule to everyone that they had to a subset of people before, the number that I’ve heard is it reduces your purchasing power as a buyer, reduces your purchasing power by approximately 20%, so if you could buy a million dollars today, if this rule comes in, you could only buy $800,000 tomorrow. Is that an accurate number? And if everyone’s purchasing power goes down by 20%, how do you think that will play out into the marketplace overall?

David Larock: Well, there’s no question, that will affect the affordability of every borrower and would be a headwind for future house price appreciation, no question. But the other thing it does, and this is … There’s the immediate impact, but then there are always related impacts that are sometimes more significant. Today, for example, I come across lots of borrowers who can’t qualify if they take a variable-rate mortgage or if they put down less than 20%, but they can qualify if they increase their down payment to 20%.

Now, if you’re a regulator looking at the market, what would you prefer? Would you rather have a high ratio borrower who barely qualifies? Or would you rather have somebody say, “You know what? I’m going to put more equity in the deal”? Granted, maybe there’s a loan from the bank of Mom and Dad. Typically though, that money is not borrowed. If somebody can’t afford a high ratio mortgage, they can’t afford to borrow the difference in the down payment to get to the 20% threshold, to not have to qualify under the stress test. The math just doesn’t work.

Today, what we have is borrowers finding other sources to increase their down payment and to increase the amount of equity they have invested in the property, which then increases the buffer that they have if house prices fall before they’re underwater. Underwater meaning the mortgage is worth more than the house. If everybody has to qualify using the stress test, then that same borrower has less incentive to try to come to the 20% threshold and increase their equity. Ultimately, then, I think it would lead to there being less equity in those next deals through the door.

Andrew la Fleur: Very interesting. Yeah, that’s …

David Larock: It would be good for the regulator.

Andrew la Fleur: Yeah, yeah. So basically, yeah, if there’s no incentive for me to get to that 20% down mark, I might as well put 5%, I might as well put 6% or whatever, as little as possible, because there’s no reason to shoot for that bar.

David Larock: Yeah, so now we have borrowers who, granted, passed the stress test but have less equity. I think there’s an argument that would be made by lots of lenders that the more equity they have in the deal, the higher their risk tolerance gets because their historical models and all their experience tells them that the more equity there is in a deal, certainly past the 20% threshold, the less likelihood there is that their loan would be at risk in any but the most severe housing downturns. Again, if OSFI is listening to the lenders, hopefully, somebody is making that point.

Andrew la Fleur: Very interesting. David, thank you so much for your time today. If people want to get a hold of you, what’s the best way for people to do that?

David Larock: Well, my website is Morplan.ca, M-O-R-P-L-A-N.ca, or they can just Google my name, David Larock. My last name is just like it sounds, L-A-R-O-C-K. Yeah, they can go to my blog. There are contact details there, and they can also check out my stuff and get a more detailed explanation of the things we’ve touched on today.

Andrew la Fleur: Excellent. Great. Thanks, David. Hopefully, we’ll have you again on the show soon. Until then, we’ll talk to you later.

David Larock: Thanks, Andrew.

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