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Interest rates at turning point as U.S. recovers

Dana Flavelle
Business Reporter

Toronto Star
September 21, 2013

Mortgage rates surge catches Canadians by surprise as U.S. stimulus drives up rates on longer-term loans

When it comes to the interest charged on mortgages and other loans, Canada is living in unusual times.

The normal indicators of which way rates might be heading seem to no longer apply. The Bank of Canada’s overnight lending rate, considered the benchmark for all other loans, has been stuck at 1 per cent for more than three years.

Yet the cost of a five-year fixed mortgage has climbed from 3.1 per cent to 3.8 per cent in just three months. That’s added just over $145 a month to the cost of the average $278,000 mortgage.

Canadians who entered their homeand car-buying years after the mid-1990s are used to low (and falling) rates, Derek Burleton, deputy chief economist at TD Bank, wrote in a recent note to clients. The sudden surge in mortgage rates has caught many by surprise and raised lots of questions, he observed

The formula used to be fairly simple: During economic downturns, the Bank of Canada would lower its benchmark rate to boost economic activity. During boom times, the bank raised the rate to curb inflation.

Then along came the financial crisis of 2008, the worst recession since the Depression of the 1930s. The near collapse of the eurozone. A slowdown in China. And the long uphill battle to restore global financial order.

Extraordinary times called for extraordinary measures. And even though many of those measures were taken by U.S. central bankers, in a global economy where money easily flows across borders, they’re having an impact on Canada.

Among them was a decision by the Federal Reserve Board to pump more money into the flagging U.S. economy through the monthly purchase of $85 billion (U.S.) in bonds. The move has helped keep longterm interest rates low by pushing down bond yields. It has also fuelled a 20 per cent rise in U.S. stock prices this year.

But it has also created an economy that’s dependent on artificial stimulus. So, when Fed chairman Ben Bernanke mused in mid-June that the Fed could begin “tapering” its purchases if the economy hit certain targets, markets were quick to react.

“That caused shock waves through financial markets and put upward pressure on interest rates,” Michael Gregory, a senior economist with BMO Capital Markets, said in an interview.

The pressure eased a bit this week after Bernanke said the Fed would hold off on plans to reduce its bond purchases. Markets had widely expected him to start cutting the program by $10 billion (U.S.) starting in October.

But most observers agree it’s only a matter of time. “It’s not a question of if, but when,” Burleton said.

And that looming change has sent bond yields (and thus mortgage rates) higher on both sides of the border.

“There’s no question Canadians are paying more,” Gregory added. “It’s not because the Bank of Canada has raised rates. And it’s not because people think the Bank of Canada will raise rates any more aggressively than they have. What has changed is pressure on global bond yields, mainly coming from the U.S.”

In other words, Canadian borrowers are starting to feel the pain of the U.S. recovery.

“Because the Canadian market is so tied to the U.S. market, you’re getting ripple-through,” Burleton said. “When U.S. bond yields rise, that tends to lead to higher yields in Canada.”

And that leads to higher interest rates on longer-term loans, such as five-year fixed mortgages.

“We’ve seen a huge run-up in the fiveyear bond yields over the past few months,” said Kelvin Mangaroo, founder of, a mortgage rate comparison website.

And there could be more to come, Mangaroo said.

“Bonds have gone up faster than mortgage rates. So there is some movement still for fixed mortgage rates to increase even more,” Mangaroo said. “We publish a mortgage rate outlook panel of industry experts each month. Our panel believes fixed mortgage rates will increase over the next 30 days.”
Future mortgage-rate hikes could be tempered by the fact that “it’s a very competitive market out there,” he added. “A lot of lenders are starting to fight over less and less mortgage clients.”

With Canadian households carrying record debt loads, even a small rise in rates could mean some homeowners will feel the squeeze.

A 1 per cent increase in the cost of a typical mortgage ( just under $278,000) would boost a homeowner’s monthly mortgage payment by $145 a month, or $1,740 a year, according to the Financial Consumer Agency of Canada

The example assumes the mortgage rate rose from 3.1 per cent to 4.1 per cent.

Bank of Canada Governor Stephen Poloz is urging consumers to use an even more conservative financial stress test.

He said this week he’s been suggesting households figure out what a 2 percentage point increase would mean to their debt payments three to five years down the road.

He’s not saying that’s where rates will be by then, Poloz added during a press conference after a speech to the Vancouver Board of Trade.

The most important factor in the price of a loan is the cost the bank paid to secure the funds, Gregory explained. Banks try to match the length of the loan to the length of the funding. Thus, a fiveyear mortgage will be backed by a fiveyear bond.

Since mid-May, the yields on five- and 10-year government bonds have jumped about 80 basis points. That’s pushed up the rate on a five-year mortgage by 70 basis points, on average, from 3.1 per cent to 3.8 per cent. There has been less impact on short-term rates, such as variable-rate mortgages with one- to threeyear terms. That’s because the shorter the term of the loan, the more closely the interest rates reflects the Bank of Canada’s overnight rate.

The Bank of Canada’s overnight rate is literally that — a one day interest rate. The chartered banks’ prime rate — the rate they charge their best corporate customers — moves up and down in lockstep with the bank rate.

Since September, 2010, the banks’ prime rate has been 3 per cent. All other loans — whether for houses, or cars, or home improvements or vacations — are based on the chartered banks’ prime rate.

Loans with short-term maturities, such as 30 day treasury bills, will trade fairly close to the one-day rate.

Longer-term loans, such as five-year fixed rate mortgages, will tend to reflect what the market thinks the overnight rate will look five years from now.

What’s bad news for borrowers may be good news for savers as rates on savings accounts and GICs also rise. But investors could suffer as higher interest rates usually mean lower stock prices.

For now, the Bank of Canada is widely expected to keep its trendsetting rate at its current ultra low level until the end of 2014.

But most observers believe it’s only a matter of time before rates start to creep up again.

And even a small three-quarter-of-apercentage point rise can have a big impact when rates are so low to begin with, Burleton said.

Posted on Wednesday, September 25, 2013 at 12:27PM by Registered CommenterElaine in | CommentsPost a Comment | References1 Reference

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