A Turning Point?

Keep an eyeball on the bond market. Five-year government bond yields rose to a 70-day high yesterday.

Today they’re up again to 2.14%, after breaking a 4-month high this morning.  Yields have been steadily climbing for five weeks.

5-year_bond_yields_20090508A Turning Point?

As savvy readers are aware, bond yields influence fixed mortgage rates. One capital markets expert told us that rates have reached an “important threshold.”  Based on current 5-year yields, “lenders should be thinking of moving rates up,” he said.

We also saw the following email yesterday from a mid-size lender: “Keep an eye on lenders’ rates–especially quick close offers”…the “increase in bond yield (and the decrease in spread–down 10 today) is something to watch…If the bond yield continues to go up, this could be a trigger for interest rates to rise.”

Mortgage shoppers (and variable-rate holders thinking of locking in) should take note.  Bond yields are pushing up lenders’ funding costs.  On a 5-year fixed, many lenders are paying a base cost of roughly 55 to 100 basis points over 5-year Canada bond yields to raise capital.  This is capital they lend out as 5-year fixed mortgages.  That equals a base funding cost of roughly 2.69% to 3.14%.  If the “average” lender wants to offer a discounted 5-year fixed rate of 3.85%, that leaves a gross spread of 0.71% to 1.06%.  That’s near or below the minimum that some lenders need to operate, given all their other operational costs.

If we see bond yields continue up, lenders may have little choice but to adjust rates higher.  The rise in yields is being fueled further by the stock market rally and recent better-than-expected economic activity.  Today’s employment reports are case in point.  Coupled with the technical and supply/demand forces now affecting bonds, all of this is bearish for bond prices and bullish for bond yields.

When Will Fixed Rates Increase?

Canadian-Fixed-Mortgage-Rates We can only guess.  Different lenders have different cost structures.  Some lenders will be able to hold out longer than others.  Scotiabank, for example, might have a 25 basis point cost advantage (or more) over a small mortgage-only lender.

That, the spring market, and vicious rate competition, will likely keep rates lower than at other historical turning points. We’re in the biggest volume quarter of the year, which is prime time for lenders to build market share.  No one will want to be the first to hike rates.

Regarding non-bank lenders, they will probably try to avoid exceeding 3.95% for the time being.  3.95% is a benchmark rate because it’s the discounted 5-year fixed rate advertised by the big banks.

What About Variable Rates?

Canadian-Bankers-Acceptance-Yields Bankers’ acceptance (BA) yields, which drive variable rates, have been holding around 0.30%-0.40%.  If the Bank of Canada keeps true to its conditional pledge, they may stay there until June 2010.

On the other hand, with one ounce of inflation above 2%, that pledge could be an afterthought. The BoC will not hesitate to raise rates if an economic recovery comes knocking sooner than anticipated.

On the funding side, big banks are currently flush with cash.  Most large deposit-taking institutions have a material advantage in variable-rate funding costs over the typical mortgage-only lender. (Interestingly, however, they’re not exercising this advantage…yet).  The capital markets consultant we spoke with pegged that advantage at 40-60 basis points.  That’s primarily because small mortgage lenders have to rely on government-backed liquidity sources (like the Canada Mortgage Bond) to generate capital for variable-rate mortgages.

As a result, unless variable-rate spreads improve (i.e., the difference between prime rate and 30-day BA yields increases), then most future near-term variable-rate deals might be through larger deposit-taking lenders.  Moreover, with the BA spread at 1.85%, and liquidity premiums (the extra that lenders need to pay to raise variable-rate capital) at 0.50% to 1.20%, the base cost of funding a variable-rate mortgage is roughly:

  • 0.90%-1.00% for a huge bank, to…
  • 1.60% for a small lender who relies on an aggregator (middleman) to resell its mortgages into the CMB market.

What This All Means to Homeowners

If you want a fixed rate, there is no reason to wait.  If bond yields keep rising, time could be an enemy.

If you want a variable rate, it doesn’t look like they’re going up anytime soon.

If you’re in a variable and are nervous about fixed rates increasing, sign up for CMT’s email updates (in the right column of this website).  If lenders start raising rates, we’ll report it.


The mandatory disclaimer:  Virtually no one can accurately and consistently predict interest rates long-term. This is not a prediction or recommendation. Market conditions can change at any time. All funding cost estimates are just that, estimates. They can change drastically from lender to lender.

  1. This confirms my thoughts as well. Seems like no better time than the present to get a fixed mortgage. Very helpful article. Thank you. M

  2. I’ve got a 1.5% closed/variable maturing in June 2013. I’m very close to pulling the trigger and locking in 3.75%.

  3. Narkis – depending on the “frills” with your mortgage…you can do better than that rate, for 3, 4, or 5 year fixed terms…

  4. Have you checked to see whether you can really shift from your closed variable to a heavily discounted fixed mortgage?
    I’ve asked my lender, and can only shift to the *posted* 5-year rates from my closed-variable (prime-0.6)

  5. ING down to 3.84% on a 5 year fixed. Quite surprising given how these bond yields are trending recently.

  6. When shifting from Variable to Fixed with RBC, you can get the greater of the “Special Offer” or your individual “Relationship Value” discount. You are not forced to take the “posted rate” like with some sub-par lenders.

  7. Nelly do you work for RBC?
    Relationship pricing rarely applies to conversions.
    The lowest conversion rates are almost always through the deep discounters (ING, PCF,….) or broker lenders (FirstLine, Merix, MCAP, Street Capital,…).
    Bank “special offer” rates are virtually always 1/10% to 1/20% above the alternatives.

  8. quote from DL…. “ING down to 3.84% on a 5 year fixed. Quite surprising given how these bond yields are trending recently.”
    DL, ING never had the lowest rates to begin with. They have more room than others to drop.

  9. Kelly W:
    You’re right about that, but don’t you think its surprising still given that 5 year bond yields are up quite a bit in the last couple weeks?
    Isn’t ING also offering the lowest rate of a national deposit taking institution? I know brokers and local credit unions that offer better of course.

  10. Is it typically possible to split a mortgage? I have a prime minus open variable and am reluctant to lock in to fixed rate although the price is good, I am somewhat worried about future inflation/rates.
    Ideally I would like a rate hold as long as possible and split my mortgage 50/50 leaving half in open variable and half locked in to a 3 to 5 year fixed after rate hold. Is this possible? costly?

  11. Hi Ottawa,
    Generally if you’re in a variable-rate mortgage you need to lock in all or nothing, or refinance into a new mortgage with hybrid capability (in which case you’d lose your prime minus variable).
    There are a few exceptions to this and I’d encourage you to talk with your existing lender to see if they can put you in a new fixed mortgage while keeping 1/2 in your prime-minus open variable.
    Mortgages with a line of credit component often allow you to lock in different portions at different rates/terms (like National Bank’s All-in-One, the Manulife One, etc.).
    Good luck!

  12. I came across this story about a month ago. It is amazing that you can foreshadow the turn in rates three weeks ahead of time! I procrastinated but still managed to lock in two days before RBC raised its mortgage rates. You probably saved us a lot of interest and I really want to thank you.
    Becky J. & family

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