Borrowers should brace themselves — the trend in interest rates has turned and is on the rise.
While the impact isn’t especially big so far, rates could surge far higher and cause greater harm if central banks struggle to contain inflation.
Marking the shift in rates was the move earlier this month by the U.S. Federal Reserve to raise its benchmark policy rate — known as the federal funds rate — for the first time in three years. A quarter-point hike brought the rate to a range of 3.75 to four per cent, with another quarter-point hike expected before year-end.
The Bank of Canada has yet to hike its policy rate — also known as the overnight rate — but markets and most economists expect it to make at least modest hikes this year or next from its current level of 2.25 per cent.
Meanwhile, some long-term rates, such as those for Canadian five-year fixed-rate mortgages and long-term bonds, have been edging up for months, partly in anticipation of future central bank rate hikes.
“That is quite a change from the start of the year,” said Douglas Porter, chief economist at BMO Financial Group. “Mostly it’s been driven by the run-up in oil prices since the beginning of the conflict in the Middle East.”
Why interest rates are rising — and what’s driving them
While the current interest-rate run-up could be significant, don’t expect it to be as dramatic as the last cycle of inflation and interest rate hikes in 2022-23.
In that cycle, Canadian inflation exploded to just over eight per cent and Bank of Canada policy rates were hiked by 4.75 percentage points from the pandemic low point before inflation was brought under control.
“This is serious, but it’s not as serious as four years ago,” Porter said. Year-over-year inflation measured by the Canadian Consumer Price Index is currently running above target at about three per cent, based on August figures. “It’s not like we’re talking about the same broad-based outbreak of inflation,” he added. “You could say that was a hurricane and this is more a howling wind and not nearly as damaging.”
How far rates rise will depend in large part on whether the conflict in the Middle East pushes oil prices higher for longer and filters through to broader price pressures. If Middle East oil starts flowing freely again, inflationary pressures should diminish and interest rates are likely to level off and possibly decline.
So far in Canada, the rising rate trend has mostly been felt with long-term borrowing and long-term bonds. Bond markets are forward-looking and incorporate expectations of policy rate changes before they happen. But the global run-up in government bond yields also incorporates other factors, including diminishing confidence in governments’ ability to prudently manage their growing debt loads.
The run-up in U.S. interest rates has been stronger than in Canada. The yield on benchmark U.S. 10-year Treasury bonds reached just over 5.1 per cent on Wednesday, the highest level since 2007. The comparable rate on 10-year Government of Canada bonds was just under four per cent.
“There are good reasons Canadian rates are lower,” Porter said. “Our inflation is a little bit lower, our unemployment is a little bit higher, our economic growth is softer,” he added, while also noting that “our problems with government finances are seen as not nearly as serious.”
How rising rates are hitting Canadian mortgage holders
Meanwhile, Canadian rates for lending and interest-generating investments that are variable or very short-term tend to follow changes to the Bank of Canada policy rate more closely and have not changed much this year.
Increases in five-year fixed mortgage rates have so far lagged surges in government bond yields, which suggests mortgage rates may be under pressure to rise further.
“The banks have been trying to keep their mortgage pipelines full and remain competitive during a slower part of the real estate cycle, so they haven’t increased fixed rates as much as one might expect,” said Robert McLister, mortgage strategist and editor of MortgageLogic.news.
The benchmark five-year Government of Canada bond yield tracks funding costs for five-year fixed-rate mortgages and is therefore a key driver of those mortgage rates. “They’re very tightly related, but they can deviate for periods of time and have done so for the last nine months or so,” McLister said.
Canadian government five-year bond yields stood at 3.57 per cent early last week, up about 90 basis points since just before the start of the Middle East conflict earlier this year.
Five-year fixed mortgage rates were 4.49 per cent early last week, up a comparatively modest 43 basis points in the same period, McLister said. (Bond and mortgage rates continued to creep up over the course of the week. One percentage point equals 100 basis points. Quoted mortgage rates are the best nationally advertised rates for well-qualified borrowers of uninsured mortgages. Mortgage payment calculations assume 30-year amortization.)
At that five-year fixed rate, monthly payments on a $600,000 mortgage would be $3,022 per month, based on McLister’s calculations. That’s up $148 a month compared with payments calculated at the best five-year rates in February.
Meanwhile, variable rates have stayed relatively stable. McLister said the best nationally advertised variable mortgage rate early last week was 3.55 per cent, which is slightly better than in February. That rate would carry monthly payments of $2,702 on a $600,000 mortgage.
Fixed or variable: Which makes more sense right now?
The current variable-mortgage rate advantage compared to five-year fixed rates is unusually large at close to 90 basis points — the average differential over the last three decades is only about 50 basis points, McLister said.
While that gap is enticing some borrowers to choose variable rates over fixed, McLister advises caution. While variable-rate mortgages make sense in some specific situations, the lower floating rate “is roping in some people who probably shouldn’t be in a variable,” he said.
Choosing a variable rate saves money if variable rates continue to hold fairly steady. But there is uncertainty about how high rates could climb. Borrowers with heavy variable-rate debt loads could suffer serious harm if variable rates soar. “It’s mainly about weighing risk versus reward,” McLister said.
Although the five-year fixed rate of 4.49 per cent is higher than earlier this year, it’s not far off the 4.35 per cent average since 1996, McLister noted.
“You’re just a touch above the three-decade average, so it’s still a solid rate.”
