## 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…

## Detailed Analysis of GTA Housing Market – up to August 2010

I have been posting housing stats for a couple months now but I never thought about seasonality… housing moves in cycles – like a lot of other markets – due to two major factors: weather and school.

The seasonal trend is very clear from this sales chart – sales increase from January to May, then slowly decrease from June to August, pick-up marginally in September and then decline gradually with a sharp drop-off in December

*The next logical question is how does seasonality affect prices?*

To look at the seasonal trend, I have charted the month-over-month change in resale home prices since 2005.

Even though most market pundits and MSM claim 2009 to be an anomaly, I think the 2009 monthly price trend sticks well to the seasonality.

Here is a line chart with the same data as above (take your pick 😉

(Note: Legend is same in all charts)

This table summarizes the above chart and shows the direction of price movement in a given month:

Period |
Price Direction |

November-January, Jun-Aug | Decreasing |

Feb-May, Sep-Oct | Increasing |

*So how does this fit into the current numbers ?*

Well, GTA prices declined about 8% from Jun-Aug… believe it or not GTA prices declined between 5-8% from 2006-2008, only in 2009 they declined by 2%… so the current trend should not be alarming. Similarly, the decline in Sales is almost in line with previous sales decline of 25-30%.

*Is this good news? *

To answer this, lets look at the year-over-year changes

Again, line chart with the same data as above year-over-year column chart

(Note: Legend is same in all charts)

The yearly downtrend is against the seasonal uptrend… so the next couple months/quarters should be key.

**Low mortgage rates might again drive demand!**

Even though prime rate has risen by 75bp or 0.75%, variable mortgage rates have not increased proportionally due to heavier discounting by mortgage brokers/banks.

Before Bank of Canada increased rates, the lowest Variable Rate was around 1.75%. Today, even after a 0.75% increase in rates, the variable mortgage rate is 2.10% – a mere 0.35% increase… so rates haven’t increased as dramatically as the media makes it sound!

Fixed Rates have been dropping in absolute in term due to the recent rally in bond markets… today you can get a 5-year fixed rate mortgage for 3.59%… which is very close to the lowest mortgage rates in 2009!

## 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

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!!

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)

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.