Canadian Interest Rates & Fixed Mortgage Rates

Fixed mortgage rates are no longer “historically low” … 1, 3 & 5 year fixed rates increased by 15, 20 & 25 basis points in the 2nd week of Feb 2011… this is the beginning of a trend that might pick up pace given that the Canadian economy (& global economy) is performing better than forecast.

BOC is scheduled to announce interest rate decision tomorrow and market expects no change to the BOC rate, currently at 1% …

The bond markets expect the BOC rates to rise 25 basis points in the next 3 months… look at the steepening yield curve.

Rising Interest Rates – thanks to QE?

If you haven’t already heard so…interest rates have reversed their downward trend to dramatically move up since the November Federal Reserve meeting, Quantitative Easing (QE2) announcement… QE2 is supposed keep US interest rates low… would you have thought that it would affect rates elsewhere?

Year-to-Date chart of Canadian interest rates…

As marked on the chart, interest rates in Canada have risen significantly over the last 6 weeks… especially the medium to long term rates in the 2-10 year terms. The 5-year rate is at 2.56%, same as in mid-July.

Here is the term chart or the Canadian yield curve… see the parallel shift in yield across all terms!

This means, borrowing costs will increase in proportion… yes, including mortgage rates, particularly fixed rates.

The 5-year fixed rates are as low as they have ever been… but they will be rising shortly; see this

The Bank of Canada hasn’t indicated any shift in monetary policy since the last rate hike in Sep-2010… so why are rates in Canada rising? Possible reasons:

· Higher inflation expectation

· Better than expected economic growth

· Bond markets are overbought

· Rising risk of default (!)

Stay tuned… I will explore each of these possibilities in the coming days…

Yield Curve Snapshot & Steepness (term spread) – Canadian Edition

As pointed by CMT, the 5-year bond yield hit a 17-month low…here is s snapshot of the yield curve now vs 3 months ago.

The following chart is rather technical and needs a slightly deeper understanding… I will try to simplify… the steepness (also called term spread) of a yield curve is measured by the difference between the longer term bonds and the shorter term bonds. Traditionally I have seen two measures:

1. difference in yield between the 30-year bonds and 90-day treasury bills (green chart)
2. difference in yield between the 10-year and 2-year bonds (blue chart).

For both charts below:

• This difference hit a multi-decade high in Spring 2009.
• The higher the difference, the steeper the yield curve (above chart).

Source: Bank of Canada

Source: Bank of Canada

What does a steep yield curve mean?

Paul Krugman provides the best explanation:

to a first approximation you can think of the long term rate as reflecting an average of expected future short-term rates. Short-term rates, in turn, tend to reflect the state of the economy: if the economy improves, the Fed will raise short-term rates, if the economy worsens, the Fed will cut. So long-term rates can be either above or below short rates.

Except that now they can’t. If the economy improves, short rates will rise; but if it worsens, well, they’re already zero (0.25%), so there’s nowhere to go but up. This implies that there has to be a positive term spread.

Until July 2010, short rates in US and Canada were 0.25%. Bank of Canada has since increased short-term rates by 0.75% to 1.00% which is why the sharp drop-off in the term spread or in other words yield curve flattening. Not only that, the long-term rates have also decreased slightly (see figure 1) which will decrease the term spread.

Now, this spread could be fairly small if people expected the economy to remain in the dumps for a long time; see Japan. What the large spread now tells us is that the US (& Canadian) economy is in the dumps now, but that investors see a reasonably good chance of a strong recovery in the not-too-distant future. That’s good news, not bad news.

Measures of Housing Affordability – is Canadian housing affordable?

This research report us by far the easiest to read, understand and perhaps right on the money!

The table below illustrates the different measures of a housing affordability and the pros/cons of each… I have written about the first 2 measures before here and here

It is worthwhile noting that method 4 – Carrying Cost is very similar to the housing affordability index published by Bank of Canada which at current levels is close to the affordable range – see chart below.

(Note: this chart is inverted so a higher point on the chart means more affordable and lower means less affordable)

For the technically inclined here is the equation for the above chart:

c = monthly payment on mortgage rate r

r = blended monthly mortgage rate reflecting fixed & variable rates

N = number of payments (300 or 25 yrs)

M0 = 0.95 x P0

P0 = value of average home

CIBC and RBC both recently published their housing reports and warned of overvaluation. I haven’t paid attention to the prior forecasts by the big banks here but I reckon some of them have been sounding the alarm bells since mid 2006-2007.

Secondly, none of these housing measures take account of “animal spirits” or simply, emotion! Let’s not forget that human emotions (along with myriad other factors) played a big role in the housing bubble down south… and housing is more often than not a very emotional purchase. Until consumers realize and understand, it is usually too late and the bubble has burst or the situation is out of hand.

Next, I’ll add a post on the share of housing to Canada’s economy… there was some chatter based on July’s GDP numbers

GTA Housing Update – Real vs Nominal

As previously mentioned, I have been posting some stats/chart on Greater Toronto Area (GTA) housing market and only now am I trying to fully understand the dynamics…

David Leonhardt at Economix (NY Times) has an interesting post on mortgage rates and (real) house prices

“Anyone who argues that home prices do not seem headed for another big decline will probably hear some version of this question. Interest rates are historically low right now. They will surely rise at some point. All else equal, higher rates should push down home prices.”

This got me thinking about the Canadian housing market – is there a correlation between mortgage rates and house prices? The following chart plots the average (nominal) house prices in Greater Toronto Area (GTA) against the 5-year (undiscounted) mortgage rates… the right half of the graph i.e. circa 1990 onwards, there is clear negative correlation between house prices and rates i.e. rates going down pushes house prices up.

David correctly points out that this relation didn’t hold in 1980s when mortgage rates shot up… house prices kept increasing!

David concludes:

“My best guess for why the two don’t correlate more closely is the role that psychology plays in housing markets. Prices just don’t move as quickly as economic theory suggests they should.”

Jake at EconomPic compares real house prices with real mortgage rates… see chart for GTA below

Note: The right scale showing real mortgage rates is inverted to better emphasize the correlation

Caveat: I’m using really crude data here: Average house prices instead of an index like the Teranet House Price Index… Unfortunately there is no index for Canadian house prices prior to 1990s.

The only conclusion I can draw from the real prices/rates chart is that Real Rates lead real house prices… the green line follows the direction and trend of the red line with a lag factor. This reinforces my conclusion from yesterday’s post that another demand push might be in the cards due to “ultra low mortgage rates”

David Rosenberg on BOC’s rate announcement & Canadian Housing Market

In Today’s Breakfast with Dave:  

The market is split on tomorrow’s Bank of Canada meeting, but most economists like round numbers and feel another hike, to 1%, is in order. We feel, based on how the economy and inflation have been moving vis-à-vis the Bank’s latest forecasts, not to mention the heightened uncertainty south of the border, that there is not enough rationale for another tightening. But monetary policy is as much an art as it is a science and perhaps Mr. Carney will take the opportunity to take out one last insurance hike.

And on housing… needless to say he is bearish

Consider that from the nearby peaks, right when the Bank of Canada embarked in its rate-hiking cycle, we have seen…    

1. Existing home sales decline 36%;
2. Single-family housing starts plunge 29% ;
3. Residential building permits slide 15% ;
4. Home prices drop 5%.  

You don’t have to do much more than study what happened to the U.S. economy three years ago to understand that the housing sector… leads. 

Flatenning Yield Curve – Canadian Bond Yields go down

Government of Canada Yield Curve flatenned since April 2010… flatenning means the long term bond yields decrease more than short-term yields… in fact short term yields on treasuries rose in direct response to increase in Bank of Canada rate in June & July 2010. 

Flatenning of yield curve is a sign of weak economic outlook and tame inflation. The economic outlook in Canada has deteriorated since April 2010… Last week’s release of Canadian economic indicators – wholesale sales, retail sales & consumer price index – were less than forecast

Source: Bank of Canada

Flatenning yield curve has the effect of reducing medium to long-term borrowing costs for business and households… E.g. – The 5-year fixed mortgage rate is priced relative to the 5-year Government of Canada bond yields which are currently at 2.4%… Usually the spread is about 120-150bps… which would mean the 5-year fixed mortgage rate should be about 2.4+1.5 = 3.9%… the best posted rate is about 4.25% … so if you are negotiating a mortgage be sure to use this and other research from here & here

Performance of Canadian assets this decade

How have various Canadian Assets performed since the heydays of 2000?

Which asset do you think appreciated the most?

stocks
bonds
commodities
your house

The chart below answers your question…

For the curious, here is the table with the relevant values:

Asset Class	Proxy	Annualized Return	Total Return (Unannualized)	Value of $100 at Start of Period
Stocks	S&P TSX Composite Index	3.67%	45.13%	$145
Bonds	iShares Canada DEX Universe Bond Index	3.94%	43.95%	$144
Commodities	Bank of Canada Commodity Price Index	5.78%	78.68%	$179
Existing Homes	Teranet House Price Index	6.22%	86.51%	$187
Inflation	Consumer Price Index	1.89%	21.30%	$121

Data Source:

Bank of Canada, Teranet, iShares & Yahoo Finance

Mortgage Rates – Fixed or Variable? Redux…

There are plenty of debates on which mortgage rate is better/cheaper to the customer… fixed or variable? Historically variable rates have been lower than fixed rates… agree but just by looking at the two rates at a point in time doesn’t prove that Variable Rate is cheaper than Fixed…

I have seen just one chart comparing the 5-year discounted Fixed Rate to the then Prime Rate (which is a proxy for Variable Rate)… This only shows that variable rate is generally lower than fixed rate at a given point in time… Most brokers forget that variable rates change throughout the term as Bank of Canada changes the bank rate…

To really prove that Variable rate is better than fixed…mostly… i took data from 1973 and calculated the Realized mortgage rate (average rate) on a Variable Rate mortgage over the 5-year term and compared it to the 5-year Fixed rate at the beginning of the mortgage term… The realized variable rate can be thought of as the average or equivalent fixed rate over the 5-year period…

And here are the results… there have been 4 instances in the past 38 years when the variable rate is cheaper than fixed rate at mortgage initation but ends up costing more than fixed rate over the full 5-year term!!

Source: Bank of Canada

what are your thoughts?

Profit Margins on Fixed Rate Mortgages

For simplicity, I will define profit on a mortgage as the difference between the interest rate that banks charge and what it costs the banks to fund that mortgage…

What banks charge is pretty straightforward to determine because it is widely advertised & there are plenty of data aggregators who compare current mortgage rate offers by institutions of all sizes from credit unions to the big five banks. Bank of Canada provides the posted mortgage rate for the last 30 years or so…

Cost of Mortgage to Banks: this depends on whether its a fixed rate mortgage or a variable/floating rate mortgage. For a fixed rate mortgage, the funding cost would usually be the yield on an equivalent term Government of Canada bond…

The current mortgage rate on 5-year fixed mortgage rate is 5.99% and the yield on a Government of Canada bond that matures in 5 years is 2.55%. The difference of 3.44% would be the banks gross profit with an astonishing gross profit margin of almost 135% (3.44/2.55)

Source: Bank of Canada

Since 1980, the profit margin has been increasing steadily as seen by the purple & red lines the chart… however, since late 2007 the profit margins have spiked and stayed there above 100%. And it is the same story for all mortgage terms i.e. 1 year, 2 year, 3 year, etc. Next I will also analyze the profit margin on variable rate mortgages.

Instead of passing on the extra savings to consumers, the banks are using the “recession” as an excuse to make wider margins. I want to know the breakdown of bank profits by division for the past couple years and why consumers haven’t benefited enough.