Fixed vs Variable Rates and Their Reaction to Bond Yield Inversion

In a strange twist in Canadian mortgage markets borrowers who lock into fixed mortgage rates now can secure lower interest rates than those opting for variable rates of interest.

By far the most popular mortgage in Canada is the five-year fixed mortgage. Now you can fix in at less than the riskier variable rate. Mortgages with fixed interest rates offer borrowers peace of mind. This is because the interest rates and repayments will not change over the term of the mortgage. Interest rates on fixed mortgages are currently at their lowest levels in two years.

Usually a fixed mortgage locked in for a full five years would cost considerably more than a variable mortgage with a free-floating interest rate which carries the risk of market volatility.

Borrowers are happy to pay more for fixed rates, because fixing the rate for the term of the mortgage offers protection against rising interest rates.

Fixed interest rates are tied to yields on government bonds of a similar length. In the normal run of things, the interest rate on long term bonds is higher than those for the shorter terms. Typically, investors over the longer term face a higher risk of volatility and economic change over the period. For this they require a higher yield.

The prime interest rate, as managed by the Bank of Canada BoC, determines the variable rate of interest. Hence the prime interest rate also determines the interest charged on a variable mortgage.

The BoC manages Prime by cutting or raising the overnight rate. The overnight rate is the rate that institutional lenders pay to borrow from the Central Bank. The bank last increased this rate to 1.75% in October 2018. There has been no movement since. Prime is currently at 3.95%.

The central bank moves the overnight rate in response to economic conditions. It is main weapon in the fight against inflation and in the management of economic growth.

We Have Another Bond Yield Inversion

In May, Canada’s ten-year yields fell to 17 points below the three-month yields. A situation where fixed rates are being forced down when variable rates remain constant is known as yield curve inversion.

This circumstance is caused by falling prices on government bonds over the short term. The last time there was a bond yield inversion was in 2007. Just before the global financial crisis. Fact is, bond yield inversions nearly always signal a major economic recession.

A bond yield inversion happens when the markets price in significant interest rate reductions in the short to medium term. The situation signals that investors believe the economy is likely to slow down, inflation will rise and the BoC will react by cutting interest rates.

The yield on government bonds is now lower than the Bank of Canada’s overnight rate of 1.75%.

Rate comparison site RateSpy.com shows that the lowest fixed rate for a conventional mortgage is 2.69%. The lowest comparable variable rate is 2.84%. It doesn’t often happen that the variable rate is priced 10 to 15 basis points below the less risky fixed rate.

Variable rates are usually around 2% lower than fixed rates. Although the market has priced in a reduction in variable rates, they are unlikely to drop any time soon. The Bank of Canada has made it clear that they have no intention of dropping rates now. A rate cut in 2020 is more likely.

The central bank uses rate cuts to boost the economy. Right now, the Canadian economy is doing very well. Inflation rates are down, GDP is tracking to 3%, up from expectations of 2.3%, and employment has gained a quarter of a million jobs since the beginning of the year. The unemployment rate in Canada is now the lowest it has been since 1976.

Fixed Mortgages Follow Government Bonds South

Because five-year fixed mortgages are determined by the Government of Canada bond market, fixed mortgages have followed the long-term government bonds south. Right now, the return on longer term bonds is better than returns over the short run. Fixed rate mortgages are showing similar trends the longer you lock in, the lower the fixed rate of interest. Currently the best mortgage options are the five-year fixed rate mortgages.

The five-year fixed mortgage has dropped 40 basis points since November last year. If you’re in the market to buy a house now may be the ideal opportunity to fix a mortgage at lower interest rates. On the other hand, if you have the stomach for higher risk you may want to hedge your bets and take a variable rate in the hope that the overnight rate will drop in the next few months.

Borrowers should, however, move with caution because in the past, yield curve inversions have been pre-cursors to recession. If the economy does go into a recession the value of property may drop.

It has been decades since there has been such a large discount of fixed to variable rates. The reason for the situation is the poor outlook for the North American economy. According to an article in RateSpy, to find a similar situation you would have to go back to the year prior to 1990 when recession hit.

Fixed rates are expected to continue their decline which will help sustain the stability of the Canadian housing market. If interest rates on mortgages do continue to decline the BoC may reduce its current qualifying rate of 5.19%, making it easier for borrowers to get a mortgage.

The BoC recently dropped the qualifying five-year benchmark from 5.34% in the first drop since September 2016. Last year stress tests were extended to all mortgage applicants, including those who were able to make a down payment of 20%. The objective was to reduce the risk of default on mortgage repayments.

The US Fed recently cut rates and unless the BoC follows suit the Canadian Dollar will start to feel the pressure. This will, in turn, have a negative impact on the Canadian economy. Nonetheless variable rates are expected to remain constant as long as the economy continues to grow.