Factors That Determine Mortgage Rates in Canada
For many years now, mortgage rates have remained at historically low levels in Canada, and most analysts expect them to increase progressively over the course of 2011 and 2012. Given the significant impact that mortgage rates have on the cost of homeownership and the housing market in general, this article focuses on the key factors that explain mortgage rate fluctuations in Canada.
First, it is important to note that the factors that determine variable mortgage rates are different than those that determine fixed mortgage rates.
Variable Mortgage Rates
Variable mortgage rates are essentially determined by commercial banks’ prime rates1, which are mainly influenced by the Bank of Canada’s key interest rate. Thus, an increase in the key interest rate almost automatically leads to an equivalent increase in variable mortgage rates. The Bank of Canada raises its key interest rate when it wants to fight inflation2.
Fixed Mortgage Rates
Fixed rate mortgage loans are primarily influenced by the yield on Canadian government bonds (bond yields) of corresponding maturity. Chart 1 shows the relationship between five-year mortgage rates3 and the yield on five-year Canadian government bonds. Notice that the correlation between the two is almost perfect. This is because bond rates represent the benchmark for financial institutions’ cost of funds4. The difference between the two rates (mortgage rates and bond yields) represents the yield that financial institutions require to lend the funds out on the mortgage market5.
In order to understand mortgage interest rate fluctuations, we need to understand the factors that influence Canadian government bond yields.
Factors Influencing Bond Yields
There are many factors that influence bond yields. Bonds issued by the Canadian government are among the most liquid and least risky assets, since they are guaranteed by the Canadian government. A significant volume of bonds are traded daily in the market. The supply and demand game in the bond market determines their price, which, in turn, determines their yield6. This yield can be seen as the minimum rate of return required by investors before investing their capital for a determined period. It is influenced by many factors, notably inflationary expectations, exchange rate risk7, and the return on other financial assets.
Here is an example, taken from current events, that helps us to understand the recent movement in bond yields. In the spring of 2010, international investors fled from volatile stock markets, as well as from government bonds issued by certain troubled European countries caught in the midst of a sovereign debt crisis. Thus, many investors flocked to the safety of the Canadian government-bond market, which was considered less risky due to Canada’s economic and financial situation. The increase in demand for Canadian government bonds pushed their price up, which necessarily lowered their yield. The shaded area on Chart 1 shows the decrease in yield on five-year Canadian government bonds that took place during this period. We can see that five-year mortgage rates followed the same trend, decreasing from 6.25 per cent in April to 5.39 per cent in August 2010.
In conclusion, mortgage rates in Canada are determined by many factors that are directly related to domestic economic activity and decisions made by Canadian financial authorities. They are also influenced by foreign economic conditions and investors’ perception of Canada’s financial and economic health.
Source:A word from the Economist~ By Paul Cardinal~Manager,Market Analysis Feb,2011 edition.
Here is the pdf file to down load if interested.
http://www.fciq.ca/pdf/mot_economiste/en/me_022011_a.pdf
