Canadian Mortgage Rates Most Likely To Climb, Despite Low Overnight Rate

Canadian home buyers may be looking at higher mortgage rates sooner than expected. At least if they want to lock in their mortgage interest rate. The 5-year Government of Canada (GoC) benchmark bond yields in February, are almost double last year’s lows. Since 5-year fixed mortgages are influenced by these rates, they are likely to climb soon. As quickly as falling rates introduced market liquidity, rising rates may reduce it. Even if the overnight rate remains untouched for the next year. 

Government Bonds and Mortgages 

Credit markets are related, since they tend to compete for a similar group of investors. Bond yields rise when demand for bonds is high, and falls when investor demand for the debt is low. The market basically self-regulates risk this way. There’s less reward when the market is crowded, and more reward when there’s more investor risk. After all, if you’re lending in a riskier situation, you should ask for more incentive to do so.

Now, let’s clarify. Government bonds aren’t risky in the sense that the government won’t pay you – at least in Canada. The largest risk for bond investors is inflation. If you’re stuck with a yield of 0.5% and inflation is 1%, you’re losing 0.5% of your money in real value over the period. There’s some cases where that’s acceptable, but generally it’s not very attractive. As inflation expectations ratchet higher, so do yields to attract investors. The opposite is also true – when inflation falls, investors may accept lower yields.

How does this relate to mortgages? Many mortgage products are influenced by government bond yields. The stronger correlation is between the GoC 5-year bond, and 5-year fixed mortgages. Since mortgages are “riskier” than GoC bonds, they have a premium for risk. Experts have observed the spread between the two is about 120 bps on average. It can be higher or lower, depending on what the market determines to be appropriate. However, generally when the 5-year GoC bond climbs, the 5-year fixed mortgage follows.

Canada’s 5-Year Bond Yield Is Almost 2x 2020’s Low

The 5-year Government of Canada (GoC) benchmark bond yield is rising from all-time lows. The yield reached 0.59% on February 18, 2021, an increase of 17 bps from just a month before. Compared to a pre-pandemic last year, the rate is still 75 bps lower, but also almost double the bottom of 0.30% reached in August 2020. This is the highest rate the market has seen since the first week of April. Granted, it’s still extremely low, but at these levels small moves translate into relatively big changes. 

5-Year Government of Canada Benchmark Bond Yield

The yield of a 5-year Government of Canada (GoC) benchark bond. Source: Bank of Canada, Better Dwelling.

Rising Rates Can Mean Less Liquidity For Sellers

Still no clue what that means, eh? Okay, let’s work through an example, if mortgages maintained the average 120 bps spread. The maximum borrowing power would have declined about ~1.9% from just the previous month. From the bottom in August, this would work out to a drop of 3.3% to the maximum mortgage size. It may not seem like much, but every reduction of borrowing power pulls back the velocity of price growth. It’s essentially a reduction in the amount of liquidity sellers have. 

Is this conclusive evidence mortgage rates will be on the rise? No, but in context things are starting to look that way. The economic recovery is much faster than the BoC had forecasted. The BoC has also stopped QE for Canada Mortgage Bonds (CMBs), which pushed rates even lower. This likely isn’t to change someone’s opinion on buying, since most buyers have no clue what it means. However, if lowering rates pulls forward buyers, rising rates tend to delay or lead to smaller budgets.

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