What do falling bond yields mean for fixed rates?

Canada's five-year government bond nosedived in July

What do falling bond yields mean for fixed rates?

Speculation about a possible recession in Canada has been growing in recent weeks thanks to rampant inflation and a flurry of Bank of Canada rate increases – and the bond market is appearing increasingly sensitive to those concerns.

The five-year government bond, which strongly influences the trajectory of fixed mortgage rates, slumped in July as inflation surged to its highest rate for nearly four decades and the Canadian economy continued to lose jobs.

That measure has fallen to around 2.80%, a far cry from its mid-June peak of 3.59%, in a fall that’s seen many lenders slash their lowest insured five-year fixed rates.

Fixed options largely took a back seat to variable rates during the red-hot market of the past two years because the latter, which rise and fall in tandem with the central bank’s benchmark rate, were available at rock-bottom borrowing costs after the Bank cut its own rate to a mere 0.25%.

Now, the prospect of a further decline in five-year fixed rates at a time when their variable counterparts are inching ever upwards raises the question of whether that trend is about to be flipped on its head, especially with further Bank of Canada hikes likely coming down the road.

That’s not only because the spread between the two is beginning to narrow, but also as borrowers may prefer the peace of mind afforded by locking into a fixed rate instead of waiting with bated breath to find out how many more times the central bank intends to raise its trendsetting rate.

Still, many mortgage brokers are advising their clients to keep faith in variable rates – including Terry Kilakos (pictured top), president at North East Real Estate & Mortgage Agency, who told Canadian Mortgage Professional that waiting it out could be the best option instead of locking in before finding out how low rates will actually go in the future.

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“A lot of people, when they see fixed rates really starting to spike up, are going to say, ‘Well, let me move over from my variable to fixed,’” he said. “In some cases, that might be a good idea, but in a lot of cases it’s actually not.

“Over the next month or so, if the [bond yield] trend continues, you’re going to start seeing those fixed rates dropping and, all of a sudden, these clients that [already] took fixed are not going to be able to get that lower interest rate. They’re going to be locked in because of the penalties they’re going to have to pay.”

With that in mind, Kilakos said his advice to variable-rate clients would be to stick with their current arrangement in the knowledge that they can switch to a potentially lower fixed rate somewhere down the line.

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“If you can kind of weather the storm or if you’re able to handle the fluctuations, I would opt to go with the variable, even though we’re in uncertain times and we know that it’s going to go up,” he said, “just to make sure that you have that flexibility to be able to convert to a different rate later on.”

Regarding the future trajectory of that bond market, much will depend on the length and severity of the recession that’s been heavily forecast.

While Royal Bank of Canada (RBC) believes a contraction will take place in 2023, that’s likely to be a “moderate” downturn, the banking giant said in July, with little prospect of the jobless rate rising to the highs of previous recessions.

It’s also set to be a “short-lived” recession by historical standards, according to RBC analysts Nathan Janzen and Claire Fan, who added that a reversal can take place “once inflation settles enough for central banks to lower rates.”

In the face of that looming economic downturn, Kilakos said he would prefer for the Bank of Canada to hit pause on its rate-hiking course while it waits to see the impact that those increases are likely to have.

“But I think that’s wishful thinking on my part,” he added. “I think they want to position themselves in such a way that in the event that they’re going to have to lower rates, they have enough wiggle room to actually do so.”