Anyone caught off-guard by mortgage rate hikes by five of Canada’s banks during the last week of March probably wasn’t paying attention to the bond market – and, let’s face it, that means most people.
A common misperception is that mortgage rates follow the Bank of Canada’s overnight lending rate. While it’s certainly true that we’ve seen historical lows in both over the last few months, the central bank only affects variable mortgage rates. Fixed-rate mortgages are affected by government bond yields, which have been trending upward for the past six weeks.
The reason? Bond traders are expecting the Bank of Canada to either raise rates sooner than the planned date of July 20 or be more aggressive in raising them than previously anticipated. Typically, the bond market moves two to four months before the Bank of Canada does.
“The bond market is a live market that can change and fluctuate constantly, but they typically move in anticipation of events, not the events themselves,” says Peter Kinch, a Vancouver-based broker. “It’s almost like a speculative market.”
Another reason behind the increase, says Benjamin Tal, senior economist at CIBC World Markets, is that U.S. government bond yields are rising and that often impacts Canada’s bond yields. “Long-term rates in the U.S. are going up primarily because of the fact that people are becoming concerned about the ability of Obama to fund the debt,” says Mr. Tal. “Unfortunately, you and I are paying for Obama’s healthcare program in a way.”
That won’t make anyone looking for a mortgage feel better. Almost all the major banks boosted their five-year mortgage rates by 60 basis points to 5.85%. Mortgage rates generally rise at a one-to-one ratio with bond yields, says Tal, and the benchmark five-year government bond yield on March 29 was 2.9%, up about 50 points since Feb. 8 and a 17-month high.
Banks like the difference between the five-year bond yield and their best — not the posted — five-year mortgage rate to be between 90 and 110, says Mr. Kinch (although others suggest the spread is 125 to above 135. That spread is the profit between what banks can secure money at and what they can sell it at in the form of mortgages.
Mr. Kinch says it’s not necessary to understand the intricacies of how bond markets work to figure out where mortgage rates are heading, just pay attention to patterns in yield changes, which are readily available online. When the spread between bond and mortgage rates goes too high, banks bring their rates down, and when the spread dips, they increase them. Since 1980 there has been a 97% correlation between the two rates on a monthly basis.
“The spread was either getting too close to 90 or may have slipped below 90, and since they were anticipating a further increase in bond yields, they priced in a 60-basis point increase to give them a buffer and create a bigger spread,” says Mr. Kinch. “If they were wrong in their predictions, they will adjust them next week.”
Mr. Kinch believes a 25-point rise in the overnight lending rate, maybe as soon as April 20, is more likely than something dramatic. That would give Bank of Canada governor Mark Carney a chance to assess any fallout before raising the rate again. However, if it looks like he’ll stand pat, bond yields will likely come down, followed by mortgage rates.
Even though bond yields change almost every day, mortgage rates don’t because that would cause consumer confusion. “Banks will move when they feel the increase is not a one-off thing,” says Mr. Tal. “They don’t want to drive everyone crazy with changing mortgage rates.”
Banks are also more likely to respond quickly to rising bond yields than they are to dropping yields, according to a Bank of Canada study in 2009 called Price Movements in the Canadian Residential Mortgage Market. That’s partly because banks generally offer 60 to 120-day rate guarantees and early payment options, both of which cost the lender if rates rise.
There are exceptions, especially if banks sweeten the pot to buy customers with lower rates. For example, bond yields on March 9 went up, but mortgage rates at RBC and BMO actually fell.
Those days would seem to be over for now, but there could be 20- to 30-point dips in mortgage rates even as they generally rise, says Mr. Kinch. “You’d be foolish to expect rates to go back down again,” he says. “The rates we saw last week, I’d be surprised if we see those again maybe in our lifetime.”
Mr. Kinch was advising people to lock into low five-year rates earlier in March after noticing the steady rise in bond yields, but notes that rates are still near historic lows. Jittery first-time homebuyers looking for security should take a fixed five-year mortgage, but consumers comfortable with a variable mortgage can find rates at less than 2%. However, Mr. Kinch recommends boosting the monthly payment to a level that would be similar to a 5% fixed rate. That accelerates debt repayment and helps adjust for higher rates down the road.
