Rates Rise, Buy Why?

When the chairman of the Federal Reserve, from the world’s largest economy (U.S.), speaks about monetary policy, markets listen. If you have any interest in the Mortgage market, and how Real Estate values can move because of these changes, continue reading …

Bond prices and bond yields explained.

Bond prices and bond yields are the inverse of each other. When central banks purchase government bonds (link) they are driving up the price of those bonds. When central banks drive up bond prices, there is a simultaneous reduction of bond yields. Low bond yields drive down fixed Mortgage rates …lower Mortgage rates encourage borrowing and drive up Real Estate asset values. Around and around we go!

Side note …I don’t think this kind of narrative is really understood or explained well in the media. I find people are rather bewildered as to what is driving Real Estate prices higher – to record highs across the country!

Taper talk.

The next question is …What happens when the largest monetary influence in the world (U.S. Federal Reserve) starts to even speak (link) about slowing their bond purchase program (this reduction of bond purchases is referred to as “tapering”)?

Well, bond purchase demand is likely to shrink. When this happens, the price of bonds decrease. Remember, bond price and bond yield are the inverse of each other. As bond prices decrease, bond yields increase resulting in upward pressure on fixed Mortgage rates.

Jerome Powell, Chairman of the U.S. Federal Reserve provided an update, that included some estimated timelines on possible reduction of bond purchases. This was enough of a signal to the U.S. bond market that yields are primed to rise.

As I’ve written to you before (link), when the U.S. catches a cold, Canada sneezes. Canada being the 10th largest economy in the world, so closely interconnected with the U.S., inevitably inherit international monetary policy. For example, Canada’s bond yields have moved in sympathy with 10 year U.S. Treasury yields (image below).

And what happens when bond yields rise? There is upward pressure on fixed Mortgage rates. I’m seeing my lenders raise fixed Mortgage rates as of time of writing this article.

If the past is any indicator of the future, we can see that fixed and variable rates move in relative lock-step with each other. So does this spell the end of ultra low, artificially stimulated Mortgage rates?

The end of ultra-low rates?

Short answer, no. I think this means we remain off the bottom of fixed interest rates lows. With the benefit of hindsight, the epic bottom of fixed interest rates was Dec 2020 – Feb 2021. The bond market spiked in March 2021 with the rollout of vaccines and the scare of inflationary pressure, only to trend sideways since. This latest surge in bond yields, from recent bond purchase taper talk by the U.S. federal reserve, is once again raising fixed interest rates.

We continue to see upward pressure on fixed interest rates. But what about variable rate Mortgages?

Fixed vs variable rate distinction.

Remember, there is a distinction between fixed and variable Mortgage rates. In Canada, the bank of Canada sets the key policy rate for our country. This central rate influences the entire economy (student loans, business loans, personal lines of credit, home equity lines of credit etc) including variable Mortgage rates. Movement up or down of this key lending rate is a very blunt economic response that takes liquidity out of the economic system.

I think central banks around the globe, including the bank of Canada (link) have been very clear of the steps leading up to rate hikes. Step one is to taper bond purchases. Step two is to sustain a level of bond purchases (purchase bonds at renewal etc). Step three is to assess various factors before hiking rates. The U.S. fed is talking about starting step one.

Higher fixed Mortgage rates might slow Canada’s housing market, which might be a welcome sign for some? If policy makers wanted to step in to slow Canada’s housing market down, without increasing the central interest rate, they can. The opposite of that same argument is also true, policy makers can step in and continually prop up the housing market. Both scenarios have a long history of precedent.

What does this mean for you?

As outlined above, fixed interest rates are seeing upward pressure due to the change in bond prices which ultimately equal higher fixed interest rates.

I think variable interest rates, that are liked to the bank of Canada’s key central rate, are a long way from rising.

One opportunity I see in the market is this …as fixed interest rates rise that should shrink current Mortgage lender Interest Rate Differential penalties. As penalties shrink, the opportunity becomes changing the Mortgage interest rate from a relativley high fixed rate, to a DEEPLY discounted variable rate. Another opportunity is keeping the original higher payment the same, which accelerates the Mortgage principal paydown, without changing the household budget. I’m anticipating this opportunity and reaching out to my clients directly to save.

Conclusion

One mention of the U.S. federal reserve talking about slowing their bond (asset) purchase program is enough to send bond yields, in both countries, higher. For context, the Bank of Canada has been actively tapering our bond (asset) purchases without a single move higher in bond yields.

Could bond yields continue to rise when the U.S. fed actually decrease their purchase program, versus hinting at starting to reduce purchases? Yup. Might this result in a stock market downturn? That is possible. If the potential market downturn is bad enough, would the U.S. fed come back to prop up markets, resuming bond (asset) purchases? Yes, precedent has been set. Quantitative Easing (QE) has been ebbing and flowing since 2008. At that time, Canadian fixed Mortgage rates would likely fall back down from previous highs.

The one caveat, that I’ve written you about, is the stagflation conundrum. Stagflation (link) is a economic scenario with persistently high inflation combined with anemic economic growth. If inflation is persistently high, with employment and overall economic growth at a stand still, a rate hike could come sooner than later? Or the inflation calculation might be changed (again?) to meet inflation targets? (maybe this is a bit of a tin foil hat moment (link)).

I hope this is somewhat helpful in understanding current market movements, sprinkled with my opinion. Thank you for reading!

Talk soon,
Chad Moore