The Coming Test for Canadian Bond Yields

The futures market is now giving 94% odds that the U.S. Federal Reserve will raise its policy rate when it next meets on December 13, 2016. While there is still much debate about whether the U.S. economy is ready for higher rates, the Fed seems determined to follow through, if only to restore some policy flexibility for fighting the U.S. economy’s next recession.

This sets up an interesting test for Government of Canada (GoC) bond yields, which have moved in virtual lockstep with their U.S. equivalents since the start of the Great Recession in 2008.

The Canadian economy continues to hover at just above stall speed and if the Bank of Canada changes its policy rate anytime soon, all indications are that it will move it lower. Given that dovish bias, will the growing divergence in our monetary policies finally lead to a decoupling in the direction of our bond yields?

If the answer seems obvious, it isn’t. The near 100% correlation between U.S. and Canadian bond yields over the past eight years is no accident.

Over that period, there have been several periods where the Canadian economy outperformed the U.S. economy, yet the correlation between our bond-yield movements has held firm, with investors essentially betting that our economy could not outperform the U.S. economy over an extended period. Investors believed that the fate of the Canadian economy was tied to the fate of the U.S. economy because exports are so vital to our economic momentum, and because we sell the vast majority of our exports into U.S. markets.

But today the conditions are different.

The U.S. economy is now outperforming the Canadian economy, and this divergence in favour of U.S. economic momentum could (and should) finally lead to a decoupling between U.S. and Canadian bond-yield movements. While Canada is the U.S. economy’s biggest export market, export sales are not nearly as important to overall U.S. economic momentum. So while bond market investors have not been willing to decouple Canadian bond yields from their U.S. equivalents fir the past eight years, the current case for doing so is now more compelling.

That said, market trends can be stubborn, so we can’t be certain that we are about to see the end of the  tight bond-yield correlation between the two countries. But if it happens, this will be a positive development for our bond yields and, by association, our mortgage rates, because it will tie them more directly to our country’s own economic performance.

Five-year GoC bond yields were flat last week, closing at 0.99% once again on Friday. Five-year fixed-rate mortgages are now available in the 2.49% to 2.69% range, depending on terms and conditions that are important to you, and five-year fixed-rate pre-approvals are offered at around 2.69%.

Five-year variable-rate mortgages are still available in the prime minus 0.30% to prime minus 0.40% range, which translates into rates of 2.30% to 2.40% using today’s prime rate of 2.70%.

The Bottom Line: U.S. bond yields have risen of late, partly in anticipation of a policy-rate hike at the Fed’s December meeting. This run-up should weaken the tight correlation between U.S. and Canadian bond yields that has held for the past eight years, because U.S. economic momentum is now clearly stronger than Canadian economic momentum. If I’m right, our fixed mortgage rates, which are priced on GoC bond yields, will hold steady in the face of additional short-term spikes in U.S. bond yields, but if I’m wrong, our mortgage rates will continue to get taken along for the ride. Stay tuned.