Understanding the basics of what determines interest rates

Over the past few weeks interest rates, specifically longer term (five-year term) fixed rates, have risen on average 0.25%. Not a massive leap, and not the beginning of the end of low rates by any stretch.

Understanding the basics.

Fixed interest rates are predicated on the bond market. Where the bond market goes is where longer term (four-year to 10-year term) fixed rates follow.

Over the past few weeks the bond market has seen new life, and thus rates have risen slightly.

This is partly due to speculation around the new federal government’s expensive commitments to inject many billions of dollars into the economy. These will be good for business, and in turn should further fuel a recovery in the bond market, making investors happier.

For those seeking longer-term fixed-rate mortgages there will be less happiness, although to be fair, for some time yet interest rates are likely to remain quite close to the record lows we have enjoyed.

An increase from 2.59% to 2.79% is hardly cause for alarm.

Variable-rate mortgages, and to some extent one, two and three-year fixed-rate mortgages, are predicated on the Bank of Canada’s prime rate, which saw two 0.25% cuts earlier this year. It’s currently at 2.70% with lenders, who passed only a 0.15% reduction on to the mortgage market.

(Side note: when the Bank of Canada increases rates by 0.25% again, will lenders increase their prime by only the 0.15% they cut, or will we get two partial cuts, but the full lump on an increase? Time will tell.)

The Bank of Canada has repeatedly said that what happens in the real estate market is not a significant part of their decision-making process; instead movement in the prime lending rate is more of a large lever designed to guide the nation’s economy as a whole.

The manic goings-on in two cities’ housing markets (Vancouver and Toronto) do not play a material role and are instead, to some extent, a by-product, not a basis for decisions.

Most notable were recent comments by our new Minister of Finance Bill Morneau, in his Fall Fiscal Update which referenced a ‘stalling economy’ and a reduction in expected economic growth from 2% to perhaps 1.2%.

These are clear indications that the Bank of Canada is unlikely to increase Prime anytime soon.

Consider that the idea of the Liberals’ commitment to infrastructure spending is an attempt to step on the gas pedal and power up the economy.

Then, equally, consider that a Bank of Canada increase to prime would be akin to stepping on the brake pedal of the economy. It seems reasonable to expect some degree of volatility in the bond market and thus longer-term fixed rates — and equally reasonable to expect stability when it comes to prime — and thus stability for variable-rate mortgages and shorter-term fixed-rate offerings.

Low rates are here for some time to come, albeit in a different form than we have grown accustomed to.

Jean-Guy Turcotte is a mortgage broker with Dominion Lending Centres – Regional Mortgage Group in Red Deer.

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