How Government Bond Yields Relate to Mortgage Rates

Are Canadian government bond yields headed lower in 2024?

This is the expectation now that the Bank of Canada (BoC) is widely anticipated to cut interest rates early next year, according to investors in the futures market. After the benchmark ten-year yield topped 4.25 percent in October, the bond has slumped below 3.5 percent. The same performance was seen with short- and long-term debt instruments.

But why should buyers and sellers in the Canadian real estate market even care about how government bonds are performing in the financial markets? One reason is mortgage rates.

Many are unaware that government bonds influence mortgage rates, affecting everything from the country’s housing sector to the household’s budget.

Let’s take a deeper dive into how government bonds affect the mortgage market.

How Government Bond Yields Relate to Mortgage Rates

A diverse array of factors can influence bond prices and yields, such as supply, inflation, monetary policy, and the economy. Traditionally, bonds are conservative investment tools because they tend to maintain an established yield over time.

As a result, financial institutions and other lenders utilize bond yields as a benchmark for what they should be providing on their fixed-rate mortgage products. Additionally, this will include a premium of as much as two percentage points.

This past fall, bond yields worldwide were surging on expectations of the central banks maintaining their higher-for-longer mantra.

In Canada, the five-year government bond, which is what banks pay most attention to in their mortgage products, soared to a 16-year high of 4.42 percent in early fall. This correlated with the five-year fixed-rate mortgage rate exceeding 6.4 percent, according to Statistics Canada.

(Yes, there are four- and seven-year mortgages, but the five-year bond is the leading indicator for what could be happening in Canada’s economy and the mortgage industry.)

However, after cooling economic and inflation data, the yield tumbled below four percent. Traders have been gradually pricing in rate cuts in early 2024, though the consensus estimate is still in the second half of 2024. It remains to be seen what the national average mortgage rate is in November and December.

It should be noted that government yields primarily affect fixed-rate mortgage products rather than their variable counterparts. Indeed, variable-rate mortgages will ebb and flow based on the BoC’s overnight interest rate target. Of course, variable-rate borrowers could witness some relief since the central bank is likely finished raising interest rates.

At the same time, there are two components to monitor. First, the volatility witnessed since September shows how quickly narratives could change. The reacceleration in inflation rates during the summer highlighted this fact. Second, mortgage lenders are quick to raise mortgage rates during a rising-rate climate, but they are not as quick to trim their mortgage rates when monetary policy is easing.

Still, there is reason for optimism after the Bank of Canada’s latest announcement, says James Laird, RateHub.ca co-CEO and CanWise mortgage lender president.

“The Bank pointed to many of its key variables moving in the right direction and inflation moving in the right direction,” he recently told Mortgage Professional. “I thought it was notable that they said the economy is no longer in excess demand. So I think mortgage borrowers should be very pleased with this announcement.”

While five-year mortgage rates and five-year bonds do not move in lockstep, the spread between these two vehicles can provide some insight into what to expect across the financial markets in the short- to medium-term.

Prepare for a Shock?

Millions of Canadians could soon face an “interest rate shock” in the next two years, warns the Canada Mortgage and Housing Corporation (CMHC).

In a recent biannual report, the CMHC projected that as many as 2.2 million mortgage holders could endure a looming rate shock upon renewal. While the delinquency rate is historically low (0.15 percent), a deeper dive into the numbers by CMHC suggested “financial strain.” This was especially true in the second quarter of 2023, which revealed a “notable” year-over-year increase in the percentage of mortgages that had been in arrears for more than 30 days.

“The decreasing ability of Canadians to make their debt payments is becoming a more significant vulnerability for the housing finance system,” the report stated.

Could the doom and gloom prognostications be averted? It all depends on the Bank of Canada and how fast the institution lowers interest rates. However, BoC senior deputy governor Carolyn Rogers told a Vancouver crowd that interest rates might stay higher for longer and might not return to the pre-pandemic time of historically low interest rates.

However, many policymakers had warned early in the quantitative tightening initiative that the housing market would plummet and the economy would crater. So far, the real estate market has been resilient, and the economy, though anemic, is holding steady. Investors – in Canada and elsewhere – anticipate rate cuts on a slowing economic landscape and cooling inflation.

Will this prediction be realized? The fresh calendar year may be a time of relief, be it inflation or borrowing costs.