Canadian mortgage rates moved higher again last week but it wasn’t because of new economic data or rising bond yields. Instead, one large lender raised rates and everyone followed, repeating a cycle that we have seen several times lately. Over the past couple of months these rounds of follow-the-leader rate changes have shrunk average five-year variable-rate discounts from prime minus 0.60% to prime minus 0.40% and increased average five-year fixed rates from 2.59% to 2.79%.
Market-wide rate changes like these are difficult to predict because they start out as subjective decisions made by one lender that everyone else then decides to follow, and in many cases, the followers have different reasons for raising than the leaders did.
Here are my thoughts on the factors that have led to these recent mortgage-rate increases:
- Lenders’ funding costs have been rising slowly but surely for some time now. The spreads between government debt and the funding vehicles that lenders use to raise capital for their mortgages have steadily widened as investors assign a higher risk weighting to these types of credit. That said, the overall increase has been relatively small and the spreads associated with our residential-mortgage funding vehicles are still miniscule when compared to the spread swaps on most other forms of credit.
- Lenders are capped on the amount of volume they can securitize into the Canada Mortgage Bond (CMB) program which is their preferred funding vehicle. When lenders reach their CMB limit, they must switch to other, more expensive sources of capital. While lenders can simply raise rates to account for these higher funding costs, they might also decide to absorb them for a while in order to stay competitive because not every lender will hit their limit at the same time. That said, if the competition raises rates, this subset of lenders will be quick to match. Also, not every lender has a viable alternative to the CMB and this group may use rate rises as a way of effectively pulling out of the market until their CMB allocation limit is reset. In this scenario, raising rates is better than officially suspending new business, which makes it harder to get new business flowing again later. Lenders who use rate rises as a way of actively discouraging volume must match any and all competitor rate increases.
- This has been a busy year for lenders and many have found themselves under staffed. Lender capacity challenges are exacerbated in the current environment because experienced underwriters are now in very short supply. With backlogs piling up, some lenders have raised rates in an attempt to temporarily slow volume and to buy their underwriting teams some breathing room. Those lenders want to maintain their defensive pricing, so they adjust upwards quickly when their competitors raise. In that same vein, the last thing other lenders who are still managing to keep up want is the surge in volume that would result if they do not raise with the rest of the market. Thus, lenders in both situations are quick to match competitor rate rises.
- Lenders price their rates aggressively in the spring market when rate competition is at its fiercest. Later in the year, especially when lenders have exceeded their volume targets, as almost all have this year, they are more inclined to take back some of the extra spread that they sacrificed to spring-market promotional pricing, even if it costs them a bit of incremental volume in the bargain.
Lenders shrank their five-year variable rate discounts in early October when Banker’s Acceptance rates started to rise in the face of higher perceived credit risk (which you can read about in detail in this article written by Rob McClister). This timing worked out well because our regulators get nervous when borrowers start piling into variable rates, and we would likely have seen just that if five-year fixed rates rose while variable rates remained unchanged. The order of these rate increases ensured that changes in the fixed/variable spread did not skew demand in favour of variable rates, thereby avoiding the ire of our new federal finance minister, who is still assessing current conditions.
These market-wide rate increases have been led by the major banks with both Scotiabank and TD taking turns leading the market higher. The banks typically announce a rate change and then wait to see if the market matches, but they don’t always. For example, when the Bank of Canada (BoC) announced its latest overnight rate cut of 0.25% in July, TD quickly dropped its prime rate by 0.10%, hoping that other lenders would follow its lead. Shortly thereafter, another major bank dropped by 0.15% and once other lenders started matching the 0.15% rate drop, TD quickly moved its prime-rate discount by another five basis points and fell back into line.
In fact, TD has tried to lead fixed-rate pricing higher on several occasions this year and until recently, these increases were met with market indifference. That’s why it’s hard to predict how other lenders will react when a large lender raises rates – without being a fly on the wall at each of their management meetings. It’s like watching a sand pile form and trying to predict which grain of sand will trigger a landslide when most cause barely a ripple.
Five-year Government of Canada (GoC) bond yields fell by one basis point last week, closing at 0.94% on Friday. Five-year fixed-mortgage rates are available in the 2.54% to 2.69% range and five-year pre-approval rates are offered at 2.79%.
Five-year variable-rates are available in in the prime minus 0.50% to prime minus 0.40% range, which translates into rates of 2.20% to 2.30% using today’s prime rate of 2.70%.
The Bottom Line: Mortgage rates moved higher again last week, but not because of GoC bond-yield movements or market reactions to new economic data. Instead, these rate rises were triggered by the culmination of the different factors listed above, and this is an important distinction because rate increases that are triggered by these circumstances are not normally a signal of the start of a broader uptrend.