After months of waiting, it finally happened on Monday. The mortgage market’s most closely watched indicator, the five-year government of Canada bond yield, rose to levels not seen since prior to the pandemic being declared in early 2020.
The five-year yield as of late day was trading near 1.07 per cent, up from 0.86 per cent just a week ago. Bond yields have risen in recent days amid hawkish developments at central banks, including suggestions from the U.S. Federal Reserve that interest rate hikes could come as early as next year.
Mortgage shoppers need to pay attention. For one thing, bond rates largely determine what you’ll pay for a new fixed mortgage. That’s because lenders benchmark their rates to yields in the financial market.
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Secondly, bond market rates, already at medium-term highs, signal rising rates ahead for both fixed and variable-rate borrowers.
In fact, financial markets are pricing in two Bank of Canada rate hikes in the next 12 months, up from just one hike last month.
WHEN WILL BANKS LIFT FIXED MORTGAGE RATES?
Barring some unforeseen crisis, variable rates aren’t going anywhere until next year, except – maybe – down another five basis points or so. (There are 100 basis points in a percentage point.)
Fixed mortgage rates are a different animal. They key off the bond market, which moves more quickly than the Bank of Canada. With an increasingly hawkish Federal Reserve prompting yields to rise, fixed rates could be vulnerable to liftoff by the time you’re eating Thanksgiving turkey, potentially much sooner.
One measure I like to look at is the spread between the lowest discounted five-year fixed rates at big banks and Canada’s five-year “swap” rate. The swap is an interest rate derivative that serves as a rough proxy for the base fixed-rate funding costs of the big banks.
This “five-year swap spread,” as trader types call it, is just 44 basis points as I write this. I’ve never seen it this low in my 14-year career. What it means is that lenders are making less than normal for every fixed-rate mortgage they sell. That can’t last for long.
Unless bond market rates pull back, the lowest fixed rates are in danger of rising at least five to 15 basis points by early October.
Interestingly, however, two factors make this time a little different. Banks are currently overflowing with liquidity thanks to: a) government support during the pandemic, and b) record amounts of deposits.
In other words, they have lots of money to lend out. As a result, some banks may be a bit more patient before they increase mortgage rates, sacrificing profit margin for market share.
Even so, this is no time to play chicken with fixed rates. So far, there’ve been no meaningful rate increases in the last week. Quite the opposite, actually.
But if locking in is your best move – given your five-year plan, finances, risk tolerance and so on – then doing so today is reasonable. Banks are still selling fixed five-year terms for less than 2 per cent, a rate that’s rarely been lower.
RISK MANAGEMENT, NOT CRYSTAL BALLING
You don’t have to be a fortune teller to use the past as a guide. Any rate watcher knows that borrowing costs historically rise amid above-target inflation, surging inflation expectations, supply/demand imbalances, labour shortages and other signs of economic recovery. That’s where we find ourselves today.
Is it possible that rates fall again? Of course. But why gamble on it? Inflation is enough of a threat to warrant rate hikes next year – so say bond traders who bet billions daily on rate direction.
All this means that fixed mortgage rates could easily approach their highs of last year before too long. That could take them up at least 50 basis points (one-half of a percentage point) by 2022, compared with today.
A half point isn’t the end of the world and probably 90 per cent of borrowers are being stress-tested by lenders at far higher rates. But a half-point is still more than $1,400 of extra interest a year – $7,000 over five years – on an average new $300,000 mortgage.
Is that enough risk to phone your lender or broker and hold the rate on a fixed-rate mortgage? That’s your call.
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