## 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…

## Canada’s Historical Inflation Rate – 1916 to 2010

## 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!!

what are your thoughts?

## Yields Plunge. Spreads Explode#comments

Fat spreads mean fat profits for lenders. It also means that fixed rates are way higher than they should be, based on the cost of funds. The last time the 5-year yield was at 2.30%, discounted five-year fixed rates were 3.75%. (The banks’ “special offer” discounted rates are 4.49% today.)

the fixed spread is high not just for the past 15 months but also historically… look at the historical spread (assuming a 1.5% discount to posted rates) since 1990… the spread was less than 1.0 % prior to 2006

What will make the banks reduce mortgage rates?

They used the credit crisis as an excuse to increase all fees (transaction & account fees) and spreads (LOC, HELOC, car loans, etc) but now that the markets are better, they haven’t reduced or discounted ANY fees or interest rates.

## 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)

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.

## Fixed Mortgage Rates – History since 1980s

Mainstream media & real-estate agents in Canada (& US alike) have been pushing the idea of all-time low mortgage rates to pump the real-estate market. Are mortgage rates really that low? The chart below does prove that the posted 5-Year Fixed Rate Mortgage (orange line) is indeed at historic lows since 1980s.

Is 1980s considered *historic* lows? May be… the Bank of Canada Interest rate from 1955 to 1980 averaged about 7% and from 1935 to 1955 about 2% which is higher than the 2009 average of 0.75%… I know this rate is more applicable to variable rate mortgages but nevertheless it helps to analyze the possible situation back then.

A Fixed Rate mortgage is one where the interest rate does not change for the term (not amortization) of the mortgage i.e. the interest rate if fixed for the term.

On the other a variable rate mortgage is one where the interest rate on the mortgage or the mortgage rate changes whenever the reference or the benchmark rate changes. In Canada the reference rate is always the Prime Rate; in US it is either the Prime Rate or the LIBOR.

## Average Prime Rate Spread by Decade

Yesterday I showed the historical difference between the Prime Rate and the Bank of Canada rate going back to 1935… that chart is quite impressive and clearly shows the low interest rate era we are living in. To draw some conclusions from that chart, I created the same chart but averaged the rate difference by decades and the numbers are quite interesting…

The Prime Rate in the current decade is 0.25% higher than the past 4 decades! What does this mean to you? Simple, higher interest costs if you have a variable rate mortgage or loan or line or credit.

Decade Average Rate Spread (%) 1930s 2.62 1940s 2.87 1950s 2.16 1960s 1.23 1970s 1.16 1980s 1.21 1990s 1.24 Current 1.55## Historical Relationship – Bank of Canada Bank Rate vs Prime Rate

Yesterday I posted a 10-year chart showing the difference between the Bank Rate which is set by Bank of Canada and the Prime Rate which is set by the chartered banks and is the rate the banks will lend to their most creditworthy customers.

Today I bring to you the same chart but going back since 1935… that’s right, the relationship between Bank Rate & Prime rate since 1935!

The spread is clearly at historic lows compared to the earlier half of 20th century but relatively high compared to the latter half