Dave Larock in Monday Interest Rate Update, Mortgages and Finances, Home Buying
Editor's Note: Monday Morning Interest Rate Update appears weekly on this blog - check back every Mon for analysis that is always ahead of the pack.
The hot question surrounding bond yields and mortgage rates these days is whether the U.S. Federal Reserve is going to raise its short-term policy rate, called the “funds rate”, later this year.
The Fed funds rate is essentially the most important interest rate in the global economy. In normal times, it provides the Fed with its most effective monetary policy tool for controlling U.S. inflation and growth rates because it serves as the base rate on which all other U.S. interest rates are priced, either directly or indirectly. In extreme circumstances quantitative easing (QE) can have a greater short-term impact over U.S. interest rates, but QE is only used as a temporary, emergency measure.
Thus the Fed funds rate has a profound influence over the U.S. economy, which is the world’s largest. Given that bond yield movements in many other countries have a high correlation with U.S. bond yield movements, any change in the Fed funds rate initiates a cascading impact that permeates throughout the global economy. This impact is keenly felt in Canada, where our Government of Canada (GoC) bond yields have moved in lock step with their equivalent U.S. treasury yields since the start of the Great Recession, and this is why anyone keeping an eye on Canadian fixed mortgage rates should keep a watchful eye on the Fed’s policy guidance.
Now on to the question of the day: Will the Fed finally raise its policy rate for the first time since 2006?
At the moment, the market thinks that it will. In fact, bond traders who speculate on such things are now betting that the Fed will raise its funds rate in September. This belief is underpinned by steadily improving U.S employment data over the past year. Specifically:
While there is no denying that the U.S. employment data have been improving, the contrarian in me is still skeptical about the market’s current bet on the Fed’s tightening timetable. Here are my concerns:
Time will tell whether the Fed will raise its funds rate this year as the markets are now expecting, but in the meantime, let’s focus on how a Fed rise is likely to impact Canadian mortgage rates.
If you are in the market for a fixed-rate mortgage this year, expect plenty of rate volatility as bond-market investors adjust their bets on what the Fed will do in response to each new economic data point. If and when the Fed announces that it will raise its funds rate, expect U.S. bond yields to spike over the short term, and if past is prologue, GoC bond yields should rise in sympathy. Since our fixed-rate mortgages are priced on GoC bond yields, they could easily move higher as the Fed’s plans to tighten monetary policy become clearer.
Variable-rate borrowers will be much more insulated from this volatility because prime rates are priced on the Bank of Canada’s (BoC) overnight rate, which is controlled by the steady hands of its interest-rate setting committee. BoC Governor Poloz continues to insist that the Bank will not be beholden to U.S. monetary policy, and he has repeatedly predicted that the BoC will lag the Fed’s monetary policy tightening timetable. Canadian bond-market investors are betting that the BoC will actually cut its overnight rate again in the near future, so at this point, they believe him.
Five-year GoC bond yields rose by six basis points last week, closing at 0.79% on Friday. Five-year fixed-rate mortgages are offered in the 2.69% to 2.59% range, and five-year fixed-rate pre-approvals are available at rates as low as 2.79%.
Five-year variable-rate mortgages are available in the prime minus 0.65% to prime minus 0.80% range, depending on the terms and conditions that are important to you.
The Bottom Line: Markets continue to gear up for the possibility that the U.S. Fed will raise its funds rate in the latter part of this year. While I think this is still not a forgone conclusion, as the prospect draws closer it should heighten bond-yield volatility and could drive our fixed mortgage rates higher in response. Meanwhile, our variable mortgage rates should be much less affected by this speculation because prime rates are controlled by the BoC, which is expected to maintain its cautious approach for the foreseeable future.
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, Move Smartly, and on his own blog: integratedmortgageplanners.com/blog Email Dave