Why the Spread Between Canadian Five-Year Fixed and Variable Mortgage Rates Is Set to Widen

When the spread between five-year fixed and variable mortgage rates is narrow, as it has been for the past two years, most borrowers have opted for the stability of the fixed rate.

That makes sense because on the one hand, they aren’t getting paid much of a discount to take on variable-rate risk, while on the other hand, the premium they have to pay for the stability of a fixed interest rate is minimal. In fact, at some points in our recent past the best five-year fixed rates were equal to or even better than their variable-rate equivalents.

This is no longer the case. The gap between our fixed and variable rates has widened of late, and my read of the tea leaves says that it will continue to do so in the near future. Today’s post explains why.

Let’s start with variable rates, which can be expected to increase when the Bank of Canada (BoC) raises its overnight rate (assuming that you don’t have a variable-rate mortgage with TD, which recently increased its variable rates on its own).

Last week the BoC left its overnight rate unchanged, as was universally expected. In its brief accompanying statement, the BoC noted the following:

• Our overall Consumer Price Index (CPI) inflation came in at 2.1% in January. This is slightly higher than the Bank’s 2% target rate, but the BoC is “looking through” what it views as a temporary rise in inflation because it still sees “material excess capacity in our economy”. The BoC is not expected to raise its policy rate until our economy absorbs this excess capacity, which it now predicts will not happen until mid-2018. (The Bank has been predicting that this excess capacity will be absorbed in somewhat the same time frame for the past eight years now, so this forecast is best viewed through a rose-coloured lens.)
• The BoC observed that “recent consumption and housing indicators suggest that growth in the fourth quarter of 2016 may have been slightly higher than expected”. This trend would be encouraging had it corresponded with rising incomes, but the Bank also acknowledged the continuation of “subdued growth in wages and hours worked”. Instead, our fourth-quarter growth spurt was fuelled by a further expansion in our household debt levels, and with the latest round of mortgage rule changes starting to bite in the first quarter of 2017, neither consumption nor housing is likely to fuel more upside surprises going forward.
• “Exports continue to face the ongoing competitiveness challenges described in the January MPR”. In that report, the Bank noted that while the Loonie had fallen against the Greenback, other currencies had weakened more. This reduced the strength of the tailwind that our more competitively priced currency gave to our exporters. In addition, the BoC noted that U.S. demand for our exports was directly tied to the demand for its own exports, because our supply chains are so integrated, so the stronger Greenback has created a headwind for our exporters.
• The BoC noted “significant uncertainties” weighing on its outlook for our economy, and anyone who watches U.S. news can understand where this uncertainty comes from, regardless of their political orientation.

Against this backdrop, I think it’s a pretty safe bet that the BoC isn’t going to raise its policy rate for some time yet, and that means that prime rates, which our variable mortgage rates are priced on, aren’t likely to move higher for the foreseeable future. Instead, the Bank will continue to use dovish policy language to jawbone the Loonie down while hoping that the U.S. Federal Reserve follows through on its plans to raise its policy rate in the near future. Speaking of which …

Canadian fixed mortgage rates are priced off of Government of Canada (GoC) bond yields which have moved in virtual lock step with their U.S. equivalents since the start of the Great Recession. As such, when the Fed starts talking about raising its policy rate and U.S. bond yields rise in response, our fixed mortgage rates get taken along for the ride (a ride that can be likened to holding onto the tail of a rather large tiger).

To be clear, I am not convinced that the U.S. economy can withstand higher rates on a sustained basis because I believe slower-than-expected growth and aging demographics will continue to assert downward pressure on U.S. economic momentum. But our fixed mortgage rates are still likely headed higher in the near future, and perhaps throughout 2017, because the Fed sounds determined to tighten its monetary policy over the short term.

Five-year GoC bond yields rose eight basis points last week, closing at 1.17% on Friday. Five-year fixed-rate mortgages are available at rates as low as 2.44% for high-ratio buyers, and at rates as low as 2.49% for low-ratio buyers. If you are looking to refinance, you should be able to find five-year fixed rates in the 2.69% to 2.84% range, depending on the terms and conditions that are important to you.

Five-year variable-rate mortgages are available at rates as low as prime minus 0.80% (1.90% today) for high-ratio buyers, and at rates as low as prime minus 0.60% (2.10% today) for low-ratio buyers. If you are looking to refinance, you should be able to find five-year variable rates in the prime minus 0.45% range (2.25% today), depending on the terms and conditions that are important to you.

The Bottom Line: Our variable mortgage rates are priced on the BoC’s overnight rate, and it doesn’t look as though the Bank will be raising this rate over the foreseeable future. Meanwhile, our fixed mortgage rates are priced on GoC bond yields, which generally move in lock step with their U.S. equivalents. Since the Fed is expected to tighten its monetary policy in the near future, we should expect our fixed-mortgage rates to be pulled higher when U.S. bond yields rise in response. As this happens, expect the spread between our five-year variable and fixed mortgage rates to increase, and the appeal of variable-rate mortgage options right along with it.