Canada was no exception to the retreat of global bond yields after the US banking crisis hit last week. The Government of Canada (GoC) 5-Year Bond yield plunged at one of the fastest rates in a generation. It wasn’t alone, with most yields falling—potentially signaling lower borrower costs. That is, if the panic-driven drop sticks around. However, it’s already showing signs of a reversal.
Government Bond Yields & Mortgages
If you understand how bond yields influence mortgages, feel free to skip ahead. For the rest of you, it’s important to understand that credit markets are competitive. Bonds of similar terms compete for capital looking for a similar allocation. Capital for a 5-year fixed rate mortgage will compete with capital for a GoC 5-Year bond. To win it over, the yield needs a slight premium to make it more attractive than a safe government bond.
As a result, bond markets directly influence fixed term mortgage rates. As they rise and fall, so do mortgage rates. The GoC 5-Year bond yield is particularly important since it’s tied to a 5-year fixed rate mortgage. The mortgage term is the most popular fixed term, and until recently the term of choice for borrowers.
Canada’s 5-Year Bond Yield Made The Fastest Drop In A Generation
Canadian bond yields plunged in response to the US banking liquidity crisis. Yesterday the 5-year GoC bond yield fell 0.38 points to close at 2.898%, following a 0.139 point drop on Friday. The two-day move is the largest in over 25 years for Canada. It matched a similar move in the US, which saw the sharpest drop since the Volcker Recession.
It’s noteworthy that it was a faster move than we saw during the Global Financial Crisis (GFC). It’s still unclear if that means it’s worse, it was mitigated, or an overreaction. In any case, it’s going to be a big part of where markets go, so pin that to your mental board.
Over the past five days, the GoC 5-year yield plunged 0.57 points, about half the amount shaved off in the past year. The yield remains a little more than a point higher than last year. Similar drops were observed for different terms, such as the 2-, 4-, and 10-year bond yields.
That’s generally good news for those looking for lower mortgage rates, but it’s not a done deal. Mortgage risk premiums can expand during a crisis to mitigate some risk. If the gap between funding and lending increases, it can absorb any of the discount. By itself, it likely means lower fixed rate mortgages if it sticks.
However, that’s fixed rate mortgages—not variable.
Canada’s Variable Mortgage Rates May Find Relief In Rate Cuts
Unlike fixed term loans, variable rate mortgages are influenced by short-term borrowing costs. In this case, the Bank of Canada (BoC) overnight rate is the influence instead of yields. The key interest rate needs to move before variable rate borrowers feel a change.
The US banking crisis is influencing this area as well. The market is now pricing in a 0.25 point cut at the BoC’s April 12th meeting, with another similar cut afterwards. By the summer, borrowers are expected to be looking at an overnight rate 0.50 points lower than the current rate. It’s a big change from the 0.25 point increase the market had expected last week, due to stubborn inflation. Risk happens fast, though it’s far from a done deal.
Drop In Yields May Be Temporary, Yields Are Reversing Course
Inflation and risk pricing are still major factors weighing on any stimulus. Inflation is close to 3x the target rate, and any stimulus can risk re-inflating it. That would be counterproductive to the central bank’s plan, rendering recent hikes useless. It can also spark even higher inflation and even higher rates down the road. This is what happened during the 80s.
Combined with US inflation coming in hot this morning, cooler heads are prevailing. The GoC 5-Year Bond yield is rallying higher, climbing 0.1 points at noon. It’s nowhere near reversing the recent drop, but still a large single-day reversal. As storm clouds clear, we’ll find out if the liquidity crisis is a smaller concern than inflation.
Currently, the market is heading in the direction of lower rates for both yield- and overnight rate-driven mortgages. The catch is those moves have to stick, which might not be the case. It’s difficult to cut rates with a hot economy and elevated inflation.
