Record Spreads as Bond Yields Keep Falling

Canada’s 5-year government bond yield has plunged yet again.  As of yesterday it was down to 1.67%.  Twelve months ago it was almost four percent! 

Meanwhile, mortgage spreads are as stubborn as ever.  The difference between 5-year posted mortgage rates and the 5-year bond yield is now a mind-blowing 5.08%.  (Fixed mortgage rates are normally linked closely to bond yields.)

That spread is more than double normal, and higher than anything we see on record (our data goes back 30 years). Not even the stratospheric interest rates of the early 1980’s caused spreads as high as we’re seeing today.

What does it all mean?  It means Canada’s mortgage market is dysfunctional--still.  It means banks are unwilling or “unable” to pass on interest rate cuts.

Based on historical norms--which naturally don’t apply in today’s market--5-year discounted fixed rates should be near 3.00%. Instead, banks are keeping them in the high 4% range. 

Even if investors theoretically demanded fat 1.00% liquidity premiums above bond yields (to compensate for the “risk” of investing in fully insured Canadian mortgages), 5-year fixed mortgage rates should still be at least 3/4% below where they are now.

So when will lenders start delivering better fixed rate discounts?  Hopefully soon, but few really know—and fewer want to tell.

(Charts and data source: Bank of Canada)

Comments

[Truth or Talk]

2 things:

The duration of banks funds is much shorter than their lending.

Perhaps the banks think that the low rate environment is abnormally low, so they don't want to get stuck mispricing their loans. In other words - they don't want to get locked in at low yields once cost of funds rises.

Secondly, the life blood of an economy is the banks. Lower rates (and wider spreads) improves bank profits which is a good thing in the face of higher credit losses.

[Mark]

It wouldn't be surprising if banks were nervous but spreads don't have to be this wide to account for interest rate risk.

What makes banks so good at predicting interest rates anyway. I bet a lot of lenders in Japan never predicted 0% interest rates there.

[Lynne Heinz]

This is a very interesting story and a very helpful web site.

Thank you

[ash]

very good information

[David A]

I highly doubt banks are 'unable' to pass on the rate cut - 'unwilling' is a better description! :)

Thanks for the article.

[Radley77]

In an era of low inflation expectations and a secular fall in interest rates, I imagine that banks may choose to add risk to funding costs to curb abnormally high rates of asset appreciation. If mortgage costs were to continue tracing downward, the end result would be higher and higher asset values that pose larger and larger risks to the financial system. Or possibly, they are looking at recovering monies after being beaten up by the variable rate market earlier this year. Lastly, if banks have larger inflation expectations and feel treasuries are overvalued, they may want to mitigate some of that risk by having higher mortgage spreads.

Flip the bond yield graph upside down and it looks like a bubble.

[Radley77]

What caused the drop in spreads in mid-2008? Here is one thought...

High energy\commodity prices supportive of strong Canadian economy gave room to reduce risk spreads. After decoupling was proven wrong, and energy\commodity prices dropped dramatically, the result was higher risk spreads were needed to cover higher default rates going forward.

[TopHomeMortgageLoan]

These spreads will continue as long as default rates remain high. I mean, who wants to lend money at such a high risk?