Be Careful What You Wish For

In case anyone hasn’t noticed – interest rates are up. It seems like every week we get another round of rate increases from lenders. No doubt it is getting tough out there in mortgage land. I am pretty certain that mortgage professionals are watching the bond more than all other financial professionals combined.

I am world of uncertainty, we look for things that we know, we look for things that we can use, and we look for things that make sense. The Canadian bond seems to fit those qualifiers. We can see the bond yield moving up, so we can quantify rates to our clients, and make some guess as to what next week can bring. When a borrower sits with us, and asks about rates, we can use tools like the Canadian bond yield to show them what has happened in the past, what is happening now, and what may happen in the future.

Almost everyone in the mortgage world would like for rates to come down. Home buyers, home sellers, and the facilitators of mortgages would all love for a reprieve from higher rates. While not trying to get too technical here – Be very careful what you wish for.

As discussed in past posts, there are 2 things that make up the rate on a mortgage. The first – and easy part, is the current 5 year bond yield. It is safe to say that if the bond yield goes up – so do the interest rates that match the term of that bond. The second thing that sets pricing is the ‘ spread ‘ over the bond. Spread is what banks use to make money, and account for risk.

When you buy a Government bond, the risk is mainly mitigated. The borrower, ie the Government is considered to be a pretty sound counter-party that will re-pay. If you are buying US or Canadian government bonds, they are pretty much considered risk free, hence why they are called the ‘ risk free rate ‘ . We can discuss the intricacies of the bond market later, but for today let’s just assume that government bonds out of Canada and the US are basically the gold standard.

However, individual borrowers are a lot more risky. Individual borrowers default, they go bankrupt, they buy over-priced assets that may be sold at an inopportune time, they lose jobs, they go to jail, etc. etc. There is a risk in lending to a person vs. a government. So, this risk has to be priced. To compensate for the increased risk, banks add a spread over the bond to determine the interest rate charged to your borrower. Today, that spread sits around 220 bps for an uninsured mortgage ( Rate of 6.54% – Bond at 4.30% ) . This is quite typical for uninsured paper. Insured is a little better with a spread around 1.54% over bond. This makes sense since insured mortgages represent a lot less risk to the lender since CMHC has picked up most of the risk.

Okay, so we know the 2 things that go into mortgage pricing, so why the title on the blog? We all want rates to drop, and the faster the better. However, generally to get interest rates to come down substantially, you need an economic train wreck. We saw this in 2020, 2015 during the oil collapse, and the grand daddy of modern times – the 2008 Great Financial Crisis. During these events bond market rates dropped precipitously, and quickly. However, although interest rates are dropping, banks are generally increasing spread to make up for the perceived increased risk in lending to an individual during an economic train wreck. In 2008 for example, we saw the spread over bond grow from around 200 bps, up to 325 bps to compensate banks for risk. When money gets scarce, credit dries up, and bankers are scared, they increase their premium to lend.

I would think that if we were to see any economic wobbles over the next 60 to 180 days, we would see bond yield start to drop. If we see bond yield drop quickly, I would expect the spread over bond to start to eat away at any – or all of the savings. Banks have proven in the past that at the first hint of problems they will not hesitate to raise spreads to cushion the blow. We last witnessed this in March of 2020 when interest rates plummeted in a week, and the 5 year fixed mortgage rate WENT UP by 30 bps.

In order to substantially and meaningfully get interest rates down ,we will need some economic issues. Those issues will most likely result in lenders increasing spread to compensate for perceived risk. Going forward, be very careful about seeing the bond yields and calculating interest rates. Just because you think you know what SHOULD happen, doesn’t mean you know what WILL happen.

Be careful what you wish for!!!