Have Bond Yields Risen Too High, Too Fast?

Canadian mortgage rates and the narratives around where they are headed have shifted dramatically since the US/Iran war started.

The Government of Canada (GoC) bond yields, which our fixed mortgage rates are based on, have spiked higher alongside oil prices. Bond-market investors are suddenly pricing in substantially more inflation ahead.

The Bank of Canada (BoC) has been more measured. It maintained a neutral policy-rate stance at its most recent meeting, to the relief of borrowers with variable mortgage rates. But that didn’t stop bond-market investors from pricing in three 0.25% hikes by the Bank this year, with the first one coming in July.

The consensus reaction is understandable.

An oil-price shock will no doubt add inflation pressure, and reassuring assessments from central bankers who underestimated the post-lockdown inflation surge don’t carry as much weight. The situation in the Middle East is so volatile that a wide range of outcomes is still possible.

But bond-market investors often overshoot when pricing in geopolitical events, and it is often true that when all the experts and forecasts agree, something different happens instead (hat tip to Bob Farrell’s ten rules of investing).

Here are five key points to support my admittedly contrarian view that bond-market investors are over-reacting to near-term inflation risks:

1. The spiking bond yields and widening credit spreads that have already occurred engender demand-supressing impacts that are like monetary-policy tightening. Simply put, the bond market is doing the BoC’s job for it.
2. Every key gauge the BoC uses to measure our inflation has now essentially returned to its 2% target. As such, there is no immediate urgency for the Bank to hike, especially at a time when our sluggish GDP and weak labour and housing markets are otherwise calling for more cuts.
3. Our labour market was much stronger at the end of COVID than it is now. That gives employees far less leverage to bargain for higher pay to compensate for higher prices. As economist David Rosenberg recently noted, “there is no such thing as sustainable inflation without a wage response.”
4. Rosenberg also recently noted that over the past forty years there have been ten oil-price spikes. In six of those cases, US core inflation either stayed the same or declined. In the worst instance, core inflation increased by 0.80%. That occurred around Gulf War 1 and was manageable at the time (despite extensive damage to oil and gas infrastructure).
5. The West Texas Intermediate (WTI) oil price has risen by about 65% thus far. A recent Economist article noted that WTI tripled during the US “Oil Shock Recession” in 1973 to 1975 and rose by 165% during the oil-price-induced US economic slowdown in 1990. Today’s WTI price would have to hit $175 to be comparable to the 1990 run-up. Given that, the author assessed that “today’s shock is closer to touching a cattle prod than to a toaster in the bathtub.”

The conflict in the Middle East appears far from over, and my view will continue to evolve alongside it. For now, my take is that bond market investors have priced in worst-case outcomes that are not yet evident.

That pessimistic pricing should make the bond market more reactive to better-than-expected news over the near term. Here’s hoping that some of that is in the offing.

The Latest on Mortgage Rates

Government of Canada (GoC) bond yields remained volatile last week but finished the week a little lower than where they started.

Lenders continued to raise their fixed rates in response to the previous bond-yield run up. Those increases have mostly run their course.

Variable-rate discounts are also shrinking as credit spreads widen.

I still expect that the BoC’s next move will be a cut to help cushion the blow from the economic damage currently being wrought by trade uncertainty and war.

My Take on Today’s Mortgage Options

Fixed rates continue to surge higher. Anyone who is actively looking to purchase within the next 120 days should lock in a pre-approval rate now.

Three- and five-year fixed rates remain the most popular choices. If the spread between those two options is minimal, I think five-year fixed rates offer better value.

Most of the borrowers I am working with right now are opting for the stability of fixed rates, and I fully appreciate their appeal.

That said, the relative saving offered by today’s variable rates has increased now that spiking bond yields are putting significant near-term pressure on fixed mortgage rates.

I continue to believe that variable mortgage rates will produce the lowest borrowing cost over their full terms, although the potential that they will take borrowers on a bumpy ride has increased since the start of the US/Iran war.

BoC Governor Macklem confirmed that the Bank will look through the oil-price spike over the near term. But if the war drags on and the inflationary impact from higher oil prices becomes more entrenched, there will come a time when the Bank must tighten.

For now, my assessment is that we won’t get to that point.

Important note: Anyone choosing a variable rate should do so only if they are comfortable with its inherent potential for volatility. Borrowers must also have the financial capacity to withstand higher costs (and in some cases, higher payments).

Insider’s Tip for Borrowers

If you want to secure a mortgage pre-approval, your broker will need to include your credit report with your application.

Many borrowers worry that this “hard pull” will negatively impact their score. But unless you’re applying for credit all over town, the impact is negligible.

This post explains how credit scores are calculated. It should also help demystify concerns about the impact that a normal-course-of-business credit pull has on a good score.

Three Posts Every New Visitor to My Blog Should Read

This post provides a detailed comparison of the pros and cons of fixed- and variable-rate mortgages amidst trade-related economic uncertainty.

For myriad reasons, some of them unanticipated, many Canadians end up having to break their fixed-rate mortgages. This post provides a detailed breakdown of the very different ways that lenders calculate their fixed-rate mortgage penalties. The amounts charged can vary significantly from lender to lender.

This post provides a detailed summary of the key terms and conditions to pay attention to in your mortgage contract. (They are not standard and can vary in important ways.)

David Larock is an independent full-time mortgage broker and industry insider who works with Canadian borrowers from coast to coast. David's posts appear on Mondays on this blog, Move Smartly, and on his blog, Integrated Mortgage Planners/blog.

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