On Thursday, one of the most-watched interest rates in the world, the U.S. 10-year yield, broke 2% for the first time since summer 2019. This is the market seeing the future — and realizing that the future likely entails more rate increases than it thought.
Many things move Canadian mortgage rates, but few are more important than U.S. yields. Yesterday’s 13-bps melt-up drove Canada’s 5-year yield to levels we haven’t seen in almost three years.
Secondly, we saw U.S. inflation hit a level we haven’t seen since February 1982. If you’re too young to remember, that was the year that Michael Jackson released “Thriller,” that “E.T. the Extra-Terrestrial” debuted, and that Canada’s prime rate was 18.97%.
Now, clearly we’re not going to witness the horror of double-digit rates this time around, but when inflation becomes embedded in people’s psyche, it leaves central bankers in cold sweats. If it turns out the Bank of Canada and the Fed were indeed asleep at the wheel, as investors increasingly fear, it’ll take more, and quicker, rate hikes to bring CPI back to target.
And yes, that’s despite the fact that prices are rising due primarily to cost-push inflation, which is running rampant due to supply interruptions. Monetary policy isn’t well-equipped to combat that.
Given that lenders benchmark fixed rates to bond yields, fixed borrowing costs will keep climbing. We’re fast running out of lenders that offer 5-year fixed rates with a two-handle. Just one national broker channel lender is left at 2.99% for a standard uninsured 5-year fixed, according to Lender Spotlight. Just 12 months ago, we were seeing record-lows of 1.84% paying full-comp.
The fixed-variable spread is now over 150 bps for the first time in over a decade. It’s getting harder to justify a fixed every time it widens. Just keep in mind that the market is pricing in a terminal rate that’s roughly 250 bps higher. Moreover, future inflation risk is unquantifiable, despite BoC assurances that CPI will slide to 3% by year-end (a level that still warrants rate hikes, by the way).
Professional mortgage advisors have an obligation to recommend suitable mortgages. That means not uniformly chanting the mantra that variable beats fixed. Borrowers who barely qualify and/or are more vulnerable to borrowing cost spikes should be put in fixed rates, albeit not necessarily 5-year-plus terms.
If you have to pick fixed, look for value in 4-year rates when appropriate, given the likelihood of rate cuts by 2026. Shaving a year off a 5-year term in exchange for a guaranteed 15-20 bps rate savings in the first 48 months is a bet worth taking. The main reason: in the post-inflation targeting world, no meaningful rate-hike cycles have lasted more than three to four years.
In less than three weeks, the Bank of Canada will get our phones ringing with the first of many rate increases. This is the time to put clients on notice that it’s about to get real.