Canadian Mortgage Rates Are Heading “Straight Up,” Will Test Real Estate: BMO

Canadian mortgage rates are set to go vertical as bond yields surge higher. BMO Capital Markets explained to clients that mortgage rates will rise “straight up.” As central banks increase the intensity for their fight against inflation, yields are rising. The result is soaring mortgage rates, expected to climb even faster in the coming months. The bank warned investors to expect surging mortgage rates to “test” real estate.

Bond Yields Are Surging Higher Everywhere

Government bond yields tend to set the standard for lending debt of similar terms. The Government of Canada (GoC) 5-year bond yield is the big one worth paying attention to. It influences the 5-year fixed term mortgage rate. As bond yields rise due to liquidity or rising inflation, these mortgages get cheaper. If liquidity falls or inflation expectations rise, mortgages get more expensive. An investor generally would like to make money over time, not volunteer a loss to inflation. 

Inflation drove bond yields soaring, especially as central banks ignored inflation. “After a clear hawkish shift within the halls of the Bank of Canada (and the Fed), 50-bp rate hikes now likely in the immediate future, and longer-term bond yields rising sharply in recent weeks, it’s straight up for mortgage rates.” said Robert Kavcic, a senior economist at BMO. 

Canadian and US Mortgage Rates Are Rising In Response

Mortgage rates respond very quickly to the bond market, especially the 5-year fixed. “In Canada, five-year fixed rates have already pushed toward 3.5%; variable rates should be north of the 3% mark by mid-summer,” he said.

A 5-year fixed rate mortgage is usually the most popular type of mortgage, but lost its spot recently. Bond yields (and fixed rate mortgages) rise with expectations. Variable rate mortgages respond to the Bank of Canada (BoC) overnight rate. Since the BoC didn’t raise rates with market expectations, it created a window of extra profit. Investors cashed in on this gap by opting for variable rate mortgages, making it the most popular. It seemed smart until now when rising interest rates can wipe out any savings fast.

It’s not a situation unique to Canada since its monetary policy tends to follow the US, for better or worse. “And, don’t forget that US mortgage rates have already jumped about 120 bps since the turn of the year,” he explains. 

Higher Mortgage Rates Will “Test” Canadian Real Estate

Higher mortgage rates reduce affordability if home prices stay the same. It’s hard for home prices to stay at the same level though, since higher rates reduce liquidity. Fewer people that can afford the amount of credit to buy at this level, which means lower price growth. If demand falls enough, prices contract — as is often the case for markets with frothy price gains. Lower prices then improve affordability, as long as home prices fail to rise after the hikes.

“For Canadian home prices, which were priced off low-1% mortgage rates (first fixed, then variable as buyers shifted to the latter), this will be a stern test…,” warns the bank. 

Last week Capital Economics suggested it would be tough to keep prices climbing. The firm said they expect higher rates to create a significant price correction. It sounds like bad news, however they don’t expect households to be significantly impacted. Home prices have increased so much, it’s hard to see losses for most long term buyers in Canada. Recent buyers that are end-users are unlikely to realize any losses as well, since they live in the home. That only leaves investors exposed, who compose a quarter to a third of demand, and are often cash flow negative.