Are Higher Mortgage Rates on the Way?

When the Bank of Canada (BoC) met for the last time before Governor Carney leaves for the Bank of England, it did not change its interest-rate bias as I had speculated that it might in last week’s post. In fact, the BoC’s commentary was a little more general and more vague than usual.

In the end, the Bank favoured a steady-as-she-goes approach as it begins to transition from outgoing Governor Carney to incoming Governor Stephen Poloz. With that in mind, I think it’s unlikely that Governor Poloz will make any significant changes to the Bank’s monetary policy right off the bat – so it now looks like the BoC’s upward interest-rate bias will be with us for a while yet.

The big story relating to Canadian mortgage rates last week was the continued surge in our five-year Government of Canada (GoC) bond yields, which have risen 33 basis points over the past month (from 1.15% on May 1, 2013 to 1.48% at close of business last Friday). To put that current yield level in perspective, over the past 12 months the five-year GoC bond yield has remained below 1.50% on all but a handful of days and we haven’t breached the 1.50% threshold since mid-February.

Marginal changes in bond yields are caused by many factors but I think the largest single influence on this recent GoC bond-yield run up has been a reduction in the fear premium that investors are willing to pay for AAA-rated assets that guarantee a return of capital. Fears of a systemic shock to the world economy, often referred to as a “tail-risk event”, have been on the wane of late. As a result, large institutional investors in search of greater returns have been rotating their massive portfolios out of ultra-safe, ultra low-rate government bonds and back into equity markets.

This selling pressure has pushed GoC bond yields up and we are now left to wonder whether this trend is just a temporary blip or the first signal that a long-term rise in our bond yields, and by association our fixed-mortgage rates, has now begun.

While there is no way to know for sure, if it’s true that the recent run up in five-year GoC bond yields is being primarily driven by diminished tail-risk fears then I don’t think we’ve seen the last of sub-1.50% yields.

Here is a look at the most pressing concerns that still surround the world’s four largest economies. These are the main reasons why I think that fear will push greed back out of the market’s driver’s seat before too long:

• We haven’t seen many ominous headlines out of the euro zone lately but we also haven’t had any significant announcements about structural improvements and/or the kind of systemic changes that the region desperately needs in order to reverse its slow and still seemingly inexorable decline. Right now the euro zone’s leaders are stalling for time until the German elections in September, but no news is not the same as good news. The region is no better positioned to handle its next crisis, and I think that will be painfully evident soon enough.
• The Bank of Japan (BoJ) has bet the proverbial farm on its latest monetary policy experiment and while markets have responded positively thus far, the experts I read believe that the BoJ has really just hit the accelerator on the country’s road to economic ruin. To demonstrate one of the many flaws in the BoJ’s approach with a simple example, consider that the BoJ is openly targeting 2% inflation, up from less than 0% today. If it reaches this target, Japanese government bond yields will surely rise by at least 2% and this would make the annual interest cost on Japan’s public debt equivalent to 80% of its total annual tax revenue.
• Chinese growth has continued to slow of late, from 7.9% in the fourth quarter of 2012 to 7.7% in the first quarter of 2013. Analysts are forecasting a further decline, to 7.5%, in the second quarter of 2013, and that is a worrying trend because China has averaged 9.3% GDP growth since 2008 and has served as the world’s primary economic growth engine over that period.
• While news out of the U.S. has been more encouraging of late, we are still witnessing its weakest recovery from recession since WWII, with GDP growth averaging about 2.0% over the past four years. This anemic growth has coincided with massive levels of federal government stimulus that has come at the cost of record debt and deficit levels. At the same time, the U.S. Federal Reserve has quadrupled the size of its balance sheet with several rounds of Quantitative Easing (QE), distorting market fundamentals and forcing investors to take on increasing levels of risk in search of higher returns. In this current “down is up” financial world, investors have tended to become more bullish in the face of bad U.S. economic news, believing that it increases the odds of more QE by the Fed. But if bad news is good news, does that mean that good news is bad news because it hastens the arrival of the day when the U.S. Fed must unwind its QE programs? And just how exactly will the Fed do this? The experts I read say that embarking on QE is as easy as squeezing toothpaste from a tube, but unwinding these programs is about as easy as trying to put that toothpaste back again. We have seen significant equity-market sell offs each time the Fed has even hinted that it may begin to taper its QE programs. An improving U.S. economy heightens the uncertainty, and fear, of what will happen when the Fed begins this process.

Five-year GoC bond yields surged 11 basis points last week, closing at 1.48% on Friday. More lenders increased their five-year fixed rates over the past week but sub-3% rates are still offered by lenders with excellent terms and conditions. Given this current upward pressure on fixed rates, borrowers who are in the market for this type of mortgage are well advised to lock in as soon as possible.

Five-year variable-rate mortgages are available in the prime minus 0.45% range (which works out to 2.55% using today’s prime rate). If fixed rates continue to rise, variable-rate borrowers will have their courage tested because conversion rates, otherwise known as their ‘emergency fixed-rate parachute’, will rise as well. At times like this, I recommend that borrowers who originated their mortgage with an experienced mortgage planner check in with him/her before making any decision on whether to convert from a variable to a fixed rate.

The Bottom Line: The recent rise in five-year GoC bond yields has triggered small fixed-rate mortgage increases at several lenders. I think this run up has been primarily caused by the growing belief among investors that the world economy’s tail-risk threats are subsiding but, in my view, the world’s largest economies continue to face significant challenges. For that reason, I think our bond yields will head lower again, and that history is likely to show that this was really just a brief period of calm before the next storm.