What the Heck is Happening to Five-Year Fixed-Mortgage Rates? (Monday Interest Rate Update)

Dave Larock in Monday Interest Rate Update, Mortgages and Finance, Home Buying, Toronto Real Estate News

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Last week borrowers saw five-year fixed-mortgage rates rise, and then
rise again, ending the era of sub-3% five-year fixed rates ... at least
for the time being.

Lenders raised their rates in reaction to
surging Government of Canada (GoC) five-year bond yields, which have now
increased by 66 basis points over the last seven weeks.

As a
first step toward understanding what all this means for our mortgage
rates over the short and medium term, let’s start by taking a look at
how we got to this point.

The run-up in five-year GoC bond yields
has occurred in three distinct phases which were fueled by separate but
mutually reinforcing factors:

  1. A
    reduction in the “fear premium” that investors were willing to pay for
    the safety of GoC bonds. During this phase, from May 1, 2013 to June 6,
    2013, the GoC five-year bond yield rose from 1.15% to 1.44%. In a post,
    written three weeks ago, I predicted that renewed fears of tail-risk
    events, like more euro-zone instability and/or a Japanese bond-market
    shock, would eventually re-inflate this premium.     GoC Bond Yields
  2. A
    near-record spike in the Canadian employment data showed 95,000 new
    jobs created in the month of May. This report was released by Statistics
    Canada on June 7, 2013 and bond yields surged 19 basis points over the
    next two trading days. In a post,
    written two weeks ago, I predicted that any impact from our May
    employment report would be minimal and highlighted several concerns with
    the details in the report that were obscured by the banner headline.
    Interestingly, bond yields fell back 9 basis points and were in retreat
    until …
  3. An announcement last Wednesday by the U.S. Federal
    Reserve that later this year it would begin tapering its massive $85
    billion per month program to purchase U.S. treasuries and
    mortgage-backed securities. The Fed also outlined a more optimistic
    economic forecast in support of this plan.

While the first
two factors weren’t enough to change my long-held view that five-year
fixed rates would not materially rise for the foreseeable future, the
U.S. Fed’s latest announcement is a potential game changer. We live in
strange times where the role of central banks has shifted from
influencing markets with an invisible hand to being an active, direct
and leading, market participant. As such, when the Fed softens its
open-ended commitment to be the marginal, and largest, buyer of U.S.
Treasuries, you can bet that U.S. Treasury yields will rise in the
aftermath. Against this back drop, higher Canadian fixed-mortgage rates
are inevitable because GoC bond yields have had a 98% correlation with
U.S. Treasury yields over the past five years (thanks to BMO economist
Doug Porter for that statistic).

But will the U.S. Fed follow
through and taper its quantitative easing programs within the timetable
it now prescribes? The Fed carefully qualified its schedule with caveats
about the economy, jobs, and (implicitly) equity markets, performing as
expected. As such, if equity markets continue to weaken, and/or
business investment and employment growth slow, these developments could
easily cause the Fed to delay its tapering plans. This is a very
realistic possibility. The experts I read have long said that starting
quantitative easing (QE) is as easy as squeezing toothpaste from a tube
and ending it is about as complicated as trying to put that toothpaste
back again (and we’re talking about the multi-coloured kind of
toothpaste in this analogy).

The Fed’s QE programs have created
massive market distortions that won’t right themselves without sending
shock waves through an economy that is still on a fragile footing.
Consider the following:

  • The U.S. Fed is counting on the
    continued recovery of the U.S. housing market but the rise their latest
    comments have triggered in Treasury yields has already pushed U.S.
    mortgage rates 0.50% higher, before any actual QE tapering has even
    begun. The U.S. housing recovery has thus far been primarily fueled by
    well-heeled private and corporate investors, not the all-important
    first-time buyers whose increased participation will be critical to any
    sustainable momentum in the housing market. First-time buyers are highly
    sensitive to these now rising mortgage-borrowing costs, especially
    since many of them are already awash in record levels of student debt.
    If the Fed’s tapering plans push Treasury yields significantly higher,
    this will create a powerful headwind for the U.S housing recovery.
  • Average
    price-to-earnings (P/E) ratios for equities are above their long-term
    averages and this latest bull-market run has recently had much more to
    do with the Fed’s ultra-loose monetary policy distorting prices than
    with actual improvements in corporate earnings. If equity markets
    continue to decline as the Fed begins to taper, this will undo the
    wealth effect that the Fed worked so hard to create in the first place
    and could easily force the Fed to slow the timing of its QE withdrawal.
  • The
    Fed revised its 2013 GDP growth forecasts for the U.S. economy down
    into the 2.3% to 2.6% range, but now calls for U.S. GDP growth to
    rebound to 3.25% in 2014, based largely on a recovery in export demand.
    Given the fragile state of the world economy, this forecast is far from
    assured. (Side note: I’ve noticed that central banks have a habit of
    raising their medium-term forecasts when lowering their short-term
    forecasts, only to then revise them gradually back down as they move
    closer to the present. The Fed appears to be following this well-worn
    playbook and as such, I am instinctively skeptical about the upward
    revision to its 2014 GDP growth forecast which got the markets so riled
    up last week. Interestingly the IMF reduced its forecast for U.S. GDP
    growth in 2014 from 3% to 2.7% last Friday.)
  • Before they
    became modern-day rock stars who determine market winners and losers,
    central bankers were charged with the boring old task of keeping
    inflation stable. The U.S. Fed’s target for inflation is 2.5% but it
    came in at 1.4% in May and in its latest commentary, the Fed
    acknowledged that inflation might drop below 1% this year. In Canada,
    our target inflation rate is 2%, and last Friday Statistics Canada
    confirmed that our latest Consumer Price Index
    (CPI) for May came in at a meager 0.7%, up from 0.4% in April. Both
    inflation rates are well under target and this implies the need for
    looser, not tighter monetary policy.

Although we ignore the
Fed’s warnings at our peril, I can’t help wondering whether the Fed’s
change in tone was really just a trial balloon to see how the market
will react when the day of reckoning, or in this case, the day of
tapering, actually arrives. The Fed certainly left itself plenty of room
to alter its timing if circumstances warrant. In the words of Ben
Bernanke: “Our policies are going to depend on this [improved] scenario
coming true. If it doesn’t come true, we’ll adjust our policies.”

the meantime, investors will carefully inspect every piece of new data
with a fine tooth comb in an attempt to pinpoint when the Fed will
actually begin to taper. This guessing game should incite more
volatility in bond yields, and markets in general, in the months to

Five-year GoC bond yields were up 29 basis points last week,
closing at 1.81% on Friday. Five-year fixed rates are now offered in
the 3.25% range while ten-year fixed rates are still available in the
3.64% range. If you value the stability of fixed rates and believe in
the strength and sustainability of the U.S. recovery, paying a small
premium (0.40%) to lock-in a rate for an additional five years of
protection seems like an easy call. If rates start to rise in a major
way, the second five years could be a lot more important than the first
five. (Most people don’t know that breaking a ten-year fixed-rate
mortgage after the fifth year only costs you a penalty of three months’
interest. For more details, here is my post on the ten-year fixed rate, which I took many years ago as my first mortgage.)

variable-rate mortgages are available in the prime minus 0.50% range
(which works out to 2.50% using today’s prime rate). Even if the Fed’s
tapering plans come off without any major hitches the removal of its QE
programs will still provide a headwind for the U.S. economy. This should
push out the timing of any change to the Fed’s policy rate, and by
close association, the Bank of Canada’s overnight rate (on which our
variable rates are based). In fact, at their latest meeting, fifteen of
the nineteen members who sit on the committee that sets the U.S. Fed’s
policy rate forecasted that it would not be increased until 2015 or

The Bottom Line: We are now at an inflection point
with mortgage rates and there are two evolving views of where we are
headed. If you believe that the U.S Fed QE taper will not cause serious
damage to the U.S. economy, with five and ten-year fixed rates so
closely aligned, I think the ten-year fixed rate is worth the 0.40%
premium you pay for the five extra years of rate certainty. If you
believe that volatility and fear will remain the watchwords of central
bankers and investors for the foreseeable future, then I think the
five-year variable rate is a far more compelling option than the
five-year fixed rate, especially given the 0.75% gap that now exists
between them.

David Larock is an independent mortgage planner and industry insider specializing in helping clients purchase, refinance or renew their mortgages. David's posts appear weekly on this blog (movesmartly.com) and on his own blog integratedmortgageplanners.com/blog). Email Dave


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