## 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

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.

## 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:

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

* *

*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.

## 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