Interest Rates Get Interesting!!

Over the last 12 months, the mortgage industry has become the largest watcher of bond yields it seems. I am convinced that mortgage brokers spend more time tracking the daily bond market than most full time bond traders. It only makes sense given the steady march higher in rates, and the havoc it is playing with consumers budgets. However, do we really know what we are looking for? Do most brokers understand what it all means? The short answer is: Probably not!!

Mortgage rates are primarily driven by 2 factors: Government of Canada bond yields, and a less known factor of discretionary pricing from lenders. It goes without saying that if the yield on the Government of Canada bond yield moves up that a lenders funding costs are generally higher. However, on top of that yield, there is the additional yield that the lender adds on to justify, and compensate them for the risk itself. Government bonds are pretty much known as ” risk free”. Simply put, you can’t get much more of a guarantee than a government bond. So, if the government bond is risk free, then everyone would buy the government bond, right? Basically yes, unless people were paid a higher yield to take on some risk. Life is all about a risk vs reward tradeoff. Everyone has a price, so to speak. Since you are taking on some additional risk buy purchasing mortgage debt, there must be a higher reward of that than a government bond yield to compensate the bond holder for taking the extra risk. This is where is gets a little subjective. Everyone has a different definition of risk, and what it represents.

Risk can mean different things to different people, and what is considered no risk today, can become very risky tomorrow. For examples of this, look no further than Sept 2008 and March of 2020. Lenders adjust their premium for taking risk above and beyond government bonds all the time. When times were good, house prices were going up up up, rates were low, unemployment was low, and housing was on fire, lenders were willing to take less reward for what seemed like a less risky bet. Today though, lenders are demanding a higher premium for mortgage debt. Lenders feel holding mortgages is riskier than it was 18 months ago, and as such, the premium – or spread over government bonds has gone up. In the summer of 2020, the government of Canada 5 year rate got as low 38 bps, and fixed rates were down to around 2.00%. However, in 2021 the Government of Canada bond was 44 bps, but fixed rates got down to around 1.49% for fixed ( high ratio insured of course ). Even though the bond was higher in 2021, mortgages rates were lower, as lender viewed less risk than they did in 2020, when COVID had the world falling apart.

Today’s market is full of risk from defaults, unemployment, war, government spending, inflation – you name it. Lenders will demand a premium to hold anything riskier than a government bond. Just because you see the Government of Canada 5 year yield drop does not mean mortgage rates will move in tandem. If we start to see economic pain, and bond rates drop, mortgage rates will not move in lock step, and will take a while to come down as lenders keep the ” risk premium” added in for themselves for risk compensation. The more volatility and uncertainty we see in the world, the less likely bond yield and mortgage rates move together.