Reviewing the relationship of interest rates and bond yields

By Mark Kerzner, President, TMG The Mortgage Group Canada Inc.

It has been said in the past that when the US sneezes Canada is very likely to catch a cold. That reference shows just how intertwined the Canadian economy is with the US. For a number of years since the start of the great recession Canada has lauded itself for its performance in the wake of extreme economic weakness in its G8 counterparts, including the US. At this time however, we seem ready to be bracing for that head cold again.

Economists are starting to forecast an economic rebound in the US beginning later this year and in to 2014.  Unemployment rates continue to drop, housing prices are starting to rebound and given what we have all learned regarding the "wealth effect" we know that when consumers feel richer they start spending. The overall economy looks like it is growing with GDP forecasts in the US now above 3%. Given this US economic optimism the FED has signalled it is going to stop purchasing $85+ billion a month in US Treasuries and Mortgage Securities (some of you may have seen this referenced as Quantitative Easing (QE)).  Note: they have not said they are stopping the capital injection, just that at some point in the future they are going to. This has the markets concerned about inflation along with economic optimism are driving yields higher.
Here is a quick refresher with respect to bond yields

• Bond yields are set like many other prices - by the forces of competition between supply and demand. One relationship to note is that as prices go up, yields go down (and vice versa).
• If there are more investors wanting to deposit their savings for 5 years (purchasing 5 year bonds) the 5-year bond yields will tend to drop
•  Bond yields will tend to increase if investors expect inflation to increase or an economy to be strong.  This happens because investors want to ensure their funds do not lose purchasing power over time
• On average, the 5-year bond rate has declined over the past 15 years.

The bond market is a good gauge for the establishment of mortgage pricing. Most financial institutions, regardless if they are selling in the MBS, CMB, etc will still use the spread between bond yields and mortgage rates as a means of establishing pricing. The historical correlation between the bond and fixed mortgage rates is over 90%.

 

And while we know there is a very strong connection between bond yields and mortgage rates what has become increasingly unclear is the spread that financial institutions are expecting to make these days. So while we can usually determine the direction of rate movement, the magnitude of those movements are somewhat harder to predict.

 

On May 1st 5 year bond yields were 1.15% - 5 year rates were 2.89% to 2.94%

On May 17th they were 1.32% - rates remained fairly stable. There were a few quick close promotions that ended.

On June 6th they were 1.42% - rates had begun to creep up and were in the 2.94% to 3.04% range

On June 19th they were 1.55% - 5 year rates continued to creep up and were in the 3.04% to 3.19% range

Today they are sitting at approximately 1.85% and we are hearing of more impending rate increases - some as high as 3.39 to 3.49%.

 

Between May 1st and today bond yields have increased by approximately 70 basis points while pricing has only increased approximately 50 to 60 basis points. That means that either there are going to be further rate increases or lenders are prepared to earn smaller spreads during this Spring market.

 

Brokers and consumers alike have all enjoyed these historical low rates as well as a prolonged period of stability (of interest rates). Now with bond yields starting to spike what does this mean for rates and where will it all net out? That is the million dollar question. If you believe that the FED will hold true to its word and stop purchasing billions in Treasuries and Mortgage Securities, the US Housing market will continue to rebound, and global economies will strengthen thereby purchasing more exports than yields will keep climbing. If on the other hand you feel that we are still not out of the words with respect to a global economic crisis and thereby a prolonged US recovery we may see some relief from this latest upward yield pressure.

 

In the meantime, the "insurance" spread of taking a 10 year term has narrowed considerably and should be considered for some, especially where payment security is sought. On the other hand, the discount of ARM to 5 year fixed (the difference in rate between a discounted variable product against a 5 year fixed) has also grown, meaning for some who feel that although yields are rising, the Bank of Canada is likely to leave the overnight rate alone for some time to come, should consider a discounted ARM.

 

We are experiencing more market volatility than we have become used to in the last little while. If it continues, and I suspect it will, we will see more regular rate movements than we have in the past 6 months or so.