May 11, 2009

A Turning Point?

Keep an eye on the bond market. Five-year government bond yields rose to a 70-day high on May 7th.

They were up again to 2.14%, after breaking a 4-month high on Friday. Yields have been steadily climbing for five weeks.

A Turning Point?

As savvy readers are aware, bond yields influence fixed mortgage rates. One capital markets expert told us that rates have reached an “important threshold.” Based on current 5-year yields, “lenders should be thinking of moving rates up,” he said.

We also saw the following from a mid-size lender: “Keep an eye on lenders’ rates--especially quick close offers”…the “increase in bond yield (and the decrease in spread--down 10 today) is something to watch…If the bond yield continues to go up, this could be a trigger for interest rates to rise.” Some lenders are pulling their quick close specials.

Mortgage shoppers (and variable-rate holders thinking of locking in) should take note. Bond yields are pushing up lenders’ funding costs. On a 5-year fixed, many lenders are paying a base cost of roughly 55 to 100 BP’s over 5-year Canada bond yields to raise capital. This is capital they lend out as 5-year fixed mortgages. That equals a base funding cost of roughly 2.69% to 3.14%. If the “average” lender wants to offer a discounted 5-year fixed rate of 3.85%, that leaves a gross spread of 0.71% to 1.06%. That’s near or below the minimum that some lenders need to operate, given all their other operational costs.

If we see bond yields continue up, lenders may have little choice but to adjust rates higher. The rise in yields is being fueled further by the stock market rally and recent better-than-expected economic activity. Today’s employment reports are case in point. Coupled with the technical and supply/demand forces now affecting bonds, all of this is bearish for bond prices and bullish for bond yields.

When Will Fixed Rates Increase?

We can only guess. Different lenders have different cost structures. Some lenders will be able to hold out longer than others. Scotiabank, for example, might have a 25 bacost advantage (or more) over a small mortgage-only lender.

That, the spring market, and vicious rate competition, will likely keep rates lower than at other historical turning points. We’re in the biggest volume quarter of the year, which is prime time for lenders to build market share. No one will want to be the first to hike rates.

Regarding non-bank lenders, they will probably try to avoid exceeding 3.95% for the time being. 3.95% is a benchmark rate because it’s the discounted 5-year fixed rate advertised by the big banks.

What About Variable Rates?

(BA)Banker acceptance yields, which drive variable rates, have been holding around 0.30%-0.40%. If the Bank of Canada keeps true to its conditional pledge, they may stay there until June 2010.

On the other hand, with one ounce of inflation above 2%, that pledge could be an afterthought. The BoC will not hesitate to raise rates if an economic recovery comes knocking sooner than anticipated.

On the funding side, big banks are currently flush with cash. Most large deposit-taking institutions have a material advantage in variable-rate funding costs over the typical mortgage-only lender ( First National / MCAP / Merix). (Interestingly, however, they’re not exercising this advantage…yet). The capital markets consultant we spoke with pegged that advantage at 40-60 basis points. That’s primarily because small mortgage lenders have to rely on government-backed liquidity sources (like the Canada Mortgage Bond) to generate capital for variable-rate mortgages.

As a result, unless variable-rate spreads improve (i.e., the difference between prime rate and 30-day Bankers Acceptance yields increases), then most future near-term variable-rate deals might be through larger deposit-taking lenders. Moreover, with the BA spread at 1.85%, and liquidity premiums (the extra that lenders need to pay to raise variable-rate capital) at 0.50% to 1.20%, the base cost of funding a variable-rate mortgage is roughly:

• 0.90%-1.00% for a huge bank, to…
• 1.60% for a small lender who relies on an aggregator (middleman) to resell its mortgages into the Canadian Mortgage Bond market.

What This All Means to Homeowners

If you want a fixed rate, there is no reason to wait. If bond yields keep rising, time could be an enemy.

If you want a variable rate, it doesn’t look like they’re going up anytime soon.

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The disclaimer: Virtually no one can accurately and consistently predict interest rates long-term. This is not a prediction or recommendation. Market conditions can change at any time. All funding cost estimates are just that, estimates. They can change drastically from lender to lender