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…

Interest Rates in the future

Ever wonder what interest rates will be in the future? If you have a mortgage, you probably have the typical 5-year (or shorter) term. At the end of your term, you have to renew your mortgage for the remaining balance at the then prevailing mortgage rates.

So how can you tell today what rates will be at the end of your mortgage term? The answer is Forward Rates, which are rates implied by current interest rates on various maturity/term bonds.

I have charted the path of 5-year bond yields on the current day (also called Spot Rate) and 2 & 5 years from current day (also called Forward Rates). In other words, the 5 year interest rate, 2 years from now and the 5 year interest rate, 5 years from now.

It is very easy to calculate forward rates and the theory is rather simple, lets calculate the 5-year rate, 2 years from today.

The formula is:

F5 = ((1+S7)^7)/((1+S2)^2)^(1/5) -1

F5 is the 5-year forward rate 2 years from today

S7 is the current 7-year spot rate (5 years 2 years from today = 7 years from today)

S2 is the current 2-year spot rate

Source: Bank of Canada

The 5-year rate, 2 years from now (red line) has been steadily trending down and is around 3.00% now which is higher than today’s 5-year rate of about 2.00%. The down trend is due to yield curve flattening or becoming less steep. I commented on this earlier today.

In other words, 5-year bond yields will increase by 1.00% in the next 2 years.

Word of Caution: Forward rates change continuously with bond yields and hence are not guaranteed future rates for any day other than current day.

You ain’t seen nothing yet, Prime-1.00 Variables

Pettis Law #17: You have not entered into the final stages of a bubble until you hear repeated use of the phrase “You ain’t seen nothing yet!”

via China Financial Markets

That is the concluding remark of Michael Pettis from his rather shorter article on excessive railroad investment in China and (ironically) the growing demand for luxury goods.

I wonder if Law# 17 applies to Canadian housing…given today’s housing affordability report and remarks like these (via Canada Mortgage Trends):

John Bordignon, EVP Strategic Development at Paradigm Quest, says, “Consumers have been asking for adjustable rate mortgages (ARMs) more and more, which in my view is one of the reasons we’ve seen such competitive pricing.”

Let me remind you that one of the biggest reasons why US housing went bust was because of variable rate mortgages or ARM – adjustable rate mortgage as they are called down south.

“In the broker channel at least 65% of the volume has been ARM versus fixed,” says Bordignon. “Historically it’s the other way around—65% fixed, and the balance ARM.

I wonder if there is a way to find out…something akin to MBA (Mortgage Bankers Association) in US. My guess is that CMHC has to have this data.

Anyway history always repeats itself… and we will return to historic norms with or without a housing bubble.

George Hugh, Vice President, Lending Sales at ING Direct, tells us: “We can’t expect much more discounting.” Hugh senses that profit spreads on variable mortgages are near their minimum.

“We’re in very abnormal market conditions. Mortgage pricing is being driven by excess demand for mortgage business from balance sheet lenders (big banks).  For the most part, these needs are being driven by securitization and other debt issuance programs.  In addition, the Big 5 banks still have a ton of deposits where they pay ‘zero’ interest…and they have to put that money to work. This excess demand is causing mortgage spreads to deteriorate. But now we’re pretty well at a floor.”

Again, it was excess demand for securitized products (MBS or RMBS to be precise) that goosed the great housing bubble.

Another cause of the housing crisis for very low mortgage rates… needless to say, rates in Canada are still pretty darn low.

Read more >> Options >>

Did Mortgage Backed Securities boost Home Ownership Rates in Canada?

In the US, there is debate within government, media and blogosphere on the role of government in the housing market… primarily in response to the poor performance of Government Sponsored housing Entities (GSE) – Fannie & Freddie… The housing GSEs were established to promote home ownership… so to fix Fannie & Freddie, home ownership needs to be fixed.

Home ownership rate (HOR) is the proportion of households who own their home (either outright or with a mortgage).

What is the situation in Canada? Since Canada supposedly lags the US housing market by a couple years… I am going to try and analyze where Canada stands and how we got here…

The Canadian housing GSE – Canada Mortgage & Housing Corporation (CMHC) was established in 1946 to solve housing shortage after WWII. Today it plays a major role in promoting home ownership by providing mortgage loan insurance since 1954.

Source: US Census Bureau via Wikipedia, Statistics Canada

Note: Unlike the US, census in Canada is every 5 years, the next one in 2011.  We can perhaps expect home ownership rates to decline if Canada indeed lags US but given the recent frenzy (see here) in housing market I somehow doubt that home ownership rates will decline… just yet. Will Canada experience a housing crash like the US? I don’t think so… see earlier posts (here & here).

So what caused home ownership rates to rise dramatically from mid 1980s to 2006 in Canada? This chart tries to answer that…

Source: Statistics Canada & Bank of Canada

As mortgage rate decreased, home ownership rate increased… BUT the role of 2-key CMHC policy changes along the way is grossly understated…

• 1986 - Introduction of Mortgage Backed Securities – reduced the funding cost for mortgage providers by letting non-bank financiers enter the housing market, thereby increase competition and reduce the cost of mortgage for a home buyer… I do not know where we would be if there was no MBS (I believe securitization is a great financial innovation)!
• 1990- 5% Minimum Downpayment – this policy change provided a huge boost to housing demand…especially from first-time home buyers.
• 1999 - 0% Down payment & 40 year mortgage terms…lets not go there, we all know how it ended!

0% down and 40 year term mortgages are no longer “legal” and are not insured by CMHC since 2008. This policy change was introduced due to rampant speculation in the housing market and a precautionary effort by Jim Flaherty to avoid a US style housing collapse.

Note: 0% down mortgages are still available by working around government policy.

Greater Toronto Area Resale House Prices… drop again

Mid-month report out for GTA house prices drop again… on track to drop for 3rd consecutive drop for a total drop of 7.5% (412934/446593 -1) from the May 2010 peak:

	Aug 2010 (mid-month)		July	June	May	April	March	February	January
Average Price	$412,934	$420,482		$435,034	$446,593	$437,600	$434,696	$431,509	$409,058
Monthly Change	-1.80%	-3.35%		-2.59%	2.06%	0.67%	0.74%	5.49%	#DIV/0!

 watch out… negotiate hard before purchasing a house

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

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?

Variable Mortgage Rates – Rollercoaster

Variable mortgage rates are quoted based on a benchmark interest rate plus/minus (+/-) a spread. In Canada the benchmark rate is almost always the bank Prime Rate. The bank Prime Rate changes when the Bank of Canada changes the overnight rate.

Today, the Variable Rate Mortgage (closed) is quoted at 2.00% and the Prime Rate is 2.5% which means the Variable Rate is (Prime Rate – 0.5%). The 0.5% is referred to as the spread over prime rate… historically this rises and falls with the credit conditions in financial markets…

Since the 2007 this spread has been on a rollercoaster ride… from -0.9% in mid-2007 to +1% in 2008 and gradually falling t0 -0.5% currently… look at the chart below…

Source: Bank of Canada

Are these spreads justified? Why haven’t the spreads fallen to -1%?

Are the banks colluding to keep rates artificially high and boost their bottom line – increase in spreads has been a major cause for rising bank profits for past 12 months…

Am I missing something here or are banks raping customers blindly?

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

Source: Bank of Canada

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.

via Yields Plunge. Spreads Explode#comments.