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Fixed Mortgage Rates Are Actually Falling (While Interest Rate Hikes!)

We are now more than a month into 2023.

No surprise, the housing market is still pretty quiet.

January sales and prices were very similar to the end of last year.

The Toronto Real Estate Board has something interesting to say.

“Home sales and selling prices appear to have found some support in recent months. This coupled with the Bank of Canada announcement that interest rate hikes are likely on hold for the foreseeable future will prompt some buyers to move off the sidelines in the coming months. Record population growth and tight labour market conditions will continue to support housing demand moving forward”.

Sounds reasonable. Nothing really new here.

But this upcoming paragraph contains 1 piece of surprising information that you might not know about.

“While short-term borrowing costs increased again in January, negotiated medium-term mortgage rates, like the five-year fixed rate, have actually started to trend lower compared to the end of last year. The expectation is that this trend will continue, further helping with affordability as we move through 2023”.

Yes, you heard it right, fixed term mortgage rates are actually coming down.

How is that possible when we just had a rate hike 2 weeks ago?

The 2 most common types of mortgages are variable and fixed.

Variable mortgages track the overnight interest rate set by the Bank of Canada.

When the interest rate goes up, the variable mortgage rate goes up.

When the interest rate goes down, the variable mortgage rate goes down.

The Bank of Canada raised the interest rate 2 weeks ago, so if you have a variable mortgage, the rate is going to go up.

What about a fixed term mortgage?

It is natural to think that the fixed rate is also going up because, well, the interest rate is going up.

That is actually a wrong perception.

Unlike variable mortgages, fixed mortgage rates do not follow the overnight interest rate.

They follow bond yields instead.

So what is a bond yield?

Let me give you a simplified view of how things work.

The bank makes money by being a lender.

It lends money to the government by buying bonds.

And it lends money to home buyers through mortgages.

Bonds and fixed rate mortgages are similar in that they earn a relatively predictable percentage of return over fixed time periods.

When the government issues a bond, it offers a guaranteed rate of return, say a 3% coupon rate, over a fixed period, say 10 years.

At the same time, bonds can also be traded in the public market, just like stocks.

When the interest rate changes, the coupon rate changes accordingly.

And that affects the bond price and the bond yield in the trading market.

From the bank’s perspective, government bonds are a very safe form of investment because they are issued by the government.

Mortgages are a similar form of investment, but they are obviously higher risk.

Of course, the bank would have to earn more from mortgages to compensate for the risk.

So the bank charges a premium above the bond yield, and that sets the rate for fixed term mortgages.

When bond yield goes up, the fixed mortgage rate goes up.

When bond yield goes down, the fixed mortgage rate goes down.

Let’s take a look at the 10-year term bond yield over the past year.

In February 2022, the bond yield was at 1.8%.

With all that rate hikes, the bond yield climbed to 3.7% in mid-October.

We just had another rate hike 2 weeks ago, but the bond yield has actually come down to 2.8%.

The declining bond yield is sending an important signal.

It is an indication that the market is projecting the Bank of Canada to cut rates later this year.

Remember when bond yield goes down, the fixed mortgage rate follows.

A 5-year fixed mortgage was at around 5.8% a few months ago, now you can negotiate a new mortgage at around 5%.

In fact, if you Google “fixed mortgage rates are falling”, you will see:

CNN headline: “Mortgage rates fall for fourth week in a row”.

The New York Times “Falling Mortgage Rates Bring Some Home Buyers Back to Market”.

Those are in the U.S.

I think we are going to see similar headlines in Canada very soon.

I would say we have pretty much hit the bottom in terms of the housing market.

We shall see.

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