Bond Yields, Inflation and Mortgage Rates

August 27, 2013 | Posted by: Mike Garganis

Earlier this year, in response to positive US economic data, the US Federal Treasury (“the Fed”) floated the idea that it might be considering an orderly winding down of its ongoing government bond buying program, known as Quantitative Easing. Equity markets immediately dropped sharply and bond yields began to rise. These two trends are usually mutually exclusive:equity markets usually perform poorly amid weak economic conditions while investors move from equities to the safety of government bonds which then drives their prices up and their yields down.

After seeing the market’s response, the Fed then backed off a little by being more vague about the extent and timing of the wind down and equity markets have since settled down but the realization that the Fed will back itself out of Quantitative Easing - at least in the medium term -has begun to hit home in the bond market. Since the Fed has been purchasing US government bonds at the rate of $85 billion every month, thereby keeping bond yields extremely low, when they do slow down and then finally stop this program, bond prices will fall and yields will rise accordingly. Since May, the bond market has moved to “price in” this coming change and yields on longer term Canadian and US government bond issues have risen sharply – in the range of 80 basis points or more.

Yields in the bond market are used as a benchmark - a basis of comparison - for the pricing of other fixed income instruments, mortgages included. Media reports often make the connection between bonds and mortgages in terms of mortgages “being financed” in the bond market but bonds and their yields represent an investment alternative to mortgages. Mortgage yields carry a spread above bond yields to compensate investors for increased risk (as small as it may be,particularly with insured mortgages) and for pre-payments and pre-payment risk. So, when bond yields rise, fixed mortgage rates also rise so that the spread is maintained.

In Canada, average best (actual as opposed to posted) five year fixed rates have risen by almost 100 basis points since May. In very broad and general terms, they have risen from a little under 3% to a little under 4%. Industry veterans will know that a 4% rate for a five year mortgage is still a very low rate by historical comparison but the recent increase is still significant. It represents a 25% increase in the interest carrying costs of a mortgage which in most cases adds more than $100 a month to an average sized mortgage payment. Many borrowers and prospective home buyers will find this recent uptick in fixed rates to be entirely manageable and easily within their budgets but some could be stretched or, for those considering entering the market, some will foresee a coming cash-flow strain and might just develop second thoughts about buying. Rate increases have always had this effect. For those with soon expiring low rate pre-approvals, as the witching hour draws ever closer, decisions must be made.

 

Inflation Outlook and Variable Rates

Statistics Canada released July inflation data on Friday. The annualized rate of inflation for the month was 1.3%, up slightly from June’s 1.2% reading. Consensus estimates were in the range of 1.4%. Transportation costs were up significantly, led by gasoline prices which increased more than 6%. The cost of new vehicles in July rose by about 2% from a year ago. Canadians did get some relief at the supermarket as overall food costs increased only 0.8%. This was the smallest increase in more than three years and reflects intense competition and some new entrants to the retail food industry.

The Bank of Canada’s core inflation index rose 1.4% in July. The Bank’s target rate for inflation is 2% and in its most recent Monetary Policy Review, it emphasized that its key overnight benchmark rate would only rise once its core inflation index began to threaten the 2% threshold. This was projected to be in about mid-2015.

For the mortgage industry, the inflation data is important in terms of the trajectory of variable rate products. As fixed rates rise in response to rising bond yields, the spread between fixed and variable widens, making variable rates much more attractive, at least in the short term. So, with the Bank of Canada not expected to move its key rate for at least another year or more, and if bond yields continue to rise, mortgage product choice may tilt further toward variable rate products.

CIBC economist Benjamin Tal commented last week that although prime rate increases are not coming any time soon, when they do come either later next year or in 2015, they could come quickly and sharply. Once inflation needs to be tamed by the Bank of Canada through monetary tightening, small incremental increases to the bank rate of 25 basis points may not be enough to do the job. By the time the Bank’s key overnight rate does rise, Mr. Tal suggested that it will have a lot of catching up to do in relation to other rates. This is expected to play out in the medium term (the next 12 to 24 months) which means that a new five year term variable rate mortgage today starting at less than 3% will very likely be subject to significant increases by at least the mid-point of the term. The extent of those increases is obviously difficult to predict. That’s why Canadians rely on mortgage professionals to guide them to the choice which is best for them.

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