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Lower Bond Yields Mean Fixed Mortgage Rates Are – Finally – Starting to Fall

Penelope Graham

After months of ever-rising rates, there may be a glimmer of hope for mortgage borrowers; five-year fixed mortgage rates have edged down slightly over the past week in response to dipping bond yields, with economic signs indicating we may have passed the price peak.

Five-year Government of Canada bond yields have slipped back under the 3% mark, falling to 2.8% as of January 18th. That’s a 22-basis-point difference in the space of a week, and down 61 bps from the end of December. As a result, some lenders have started to lower their fixed five-year offerings, with the best mortgage rate in Canada now at 4.39%, compared to 4.54% last week. That 15-point gap may be small – but in today’s steep interest rate environment, it’s promising to see any sign of relief. As well, should current economic trends continue, there could be more rate stabilization for fixed-rate borrowers in the near future.

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In a research note, BMO Senior Economist Robert Kavcic writes, “Canadian mortgage rates should now be at or near their peaks if the rest of this cycle plays out as expected. The BoC is expected to raise rates another 25 bps next week, which could mark the end of the upward march in variable mortgage rates. Meantime, the rally in Treasuries and GoCs has pulled down five-year yields in Canada to around the 2.8% mark, below the lows set in December last year.” 

He adds that while today’s rates are well above the 1.5% range available just one year ago, the “stall in upward momentum should help at the margin, and offer some confidence that the worst of the rate shock is behind us.”

Why are bond yields falling?

Promising inflation numbers out this week, along with growing expectations that the Bank of Canada is wrapping up its rate hiking cycle, are contributing to the current dip in bond yields. That’s because yields react directly to shifts in the economy. Generally, when economic conditions are rosy, demand spikes for government bonds, which in turn increases their prices and lowers their yields; the two have an inverse relationship.

To get a better grasp, let’s take a closer look at how the bond market works.

What is a bond?

A bond is an investment type where the investor receives a return – known as the yield – in exchange for depositing their funds for a set term (the most popular are two-, five-, and 10-year terms). At the end of the term, when the bond reaches maturity, the investor receives their money back along with the promised interest income yield. 

The amount of interest income is what makes bonds competitive in relation to each other. When interest rates rise, any bonds issued after the fact are more valuable than existing ones. This means any Bank of Canada rate hike devalues existing bonds, which then must be sold at a discount. 

As bonds get cheaper, their yield must increase in order to continue to attract investors. As the Bank of Canada has increased the benchmark interest rates by 4% between March and December 2022 – bringing its Overnight Lending Rate to 4.25% today – bond yields have surged over 350 basis points from trough to peak.

How inflation impacts the bond market

Inflation is another factor that impacts bond yields, which are whittled away as the consumer price index rises. Stubbornly steep inflation – which hit a 40-year high of 8.1% this June – has pushed bond yields higher over the course of 2022. However, the most recent December CPI showed inflation growth has since chilled to 6.3%; that indicates the Bank of Canada may end its hiking cycle or hold off on any rate movement in its upcoming January 25th announcement, which has boosted bond demand (and therefore lowering yields) in the short term.

To give you a better idea of how inflation impacts bonds, the highest five-year yield ever recorded in Canada was 18.78% in September 1981, back when CPI sat at a whopping 12.47%! Conversely, the all-time low was the 0.276% yield recorded in March 2020; inflation rose just 0.9% that month as pandemic fears and lockdowns paralyzed the economy.

How do yields affect fixed mortgage rates?

Government of Canada bonds are considered to be particularly attractive and stable investments; as they’re backed by the government, they offer investors a relatively risk-free profile, and are highly liquid.

As such, they are also used by consumer lenders to set the benchmark cost for fixed-rate borrowing products at a spread of roughly 100 - 200 basis points above the five-year yield; today’s best five-year rate of 4.39% is sitting 159 basis points higher. Should yields fall lower, consumers can expect to see deeper fixed mortgage rate discounts from lenders.

The bottom line

While today’s fixed mortgage rate options remain elevated to where they were just a year ago, there is growing optimism that slowing inflation will help them stabilize or lower slightly in the near future – and that’s great news for anyone currently shopping for a mortgage. As rate conditions can shift quickly amid evolving economic conditions, it’s smart for borrowers to frequently shop around in the coming months to ensure they’re getting the best rates. Connecting with a mortgage broker is one way to stay on top of market changes – at no cost to you. 

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