Why US Fed Rate Hike Means Higher Canadian Mortgage Rates

It always amazes me just how quickly Canadian consumers forget how dependent the Canadian economy is on the US economy. Simply put… the Canada-US trade relationship is one of the single biggest trading relationships in the world. So if the US Federal Reserve does raise rates in December 2015, as widely expected, it will be the first time it has done so since 2006.

So just how big is the news that one of the world’s most influential economies (and Canada’s single largest trading partner) is moving rates for the first time in nearly ten years? Well, it’s very likely the single biggest global financial headline of the year when it comes to monetary policy.

So why does the US impact us so much more than we impact them? It is really quite simple – they have ten times the population base and accordingly nearly ten times the economic engine size (nominal GDP estimates from financial and statistical institutions). Put even more simply – they have ten times the impact on our economy than we have on theirs.

Central Banks vs Bond Markets

There is a common misconception that the central bank interest rates and longer term bond yields are closely correlated and this is not necessarily always the case. What most people miss is that while our central bank moves its overnight lending rate up and down according to what has happened with recorded inflation at eight predetermined announcement dates, on the other hand, bond markets trade on expectations for inflation (not necessarily what has happened, but more precisely what market participants think will happen).  What this means for mortgage borrowers is that fixed mortgage interest rates move in accordance with the bond markets and not necessarily in response to Bank of Canada overnight rate changes. At the same time it is important to note that a major policy change by a central bank can have a much broader based reach throughout markets at large.

We can see from the chart above that the 5-year government of Canada bond, which has the single largest influence on the cost of five year fixed mortgage rates (the single most popular mortgage product in the history of the Canadian mortgage market) has moved from a low of 0.55% in August to trading just under 1% today. It has been this increase of over 0.25% in the last month that has meant five year discounted rates have been creeping up. All this time – I have been repeatedly writing about why this is very likely the very best time to refinance in Canadian history and ten of thousands of Canadians have unbelievably sat on the sidelines waiting for … yes – lower rates! That 0.55% was not only the lowest 5-year bond yield this year, but the single lowest recorded in our entire lifetime. Despite this fact – variable and not fixed rates were surging in popularity. If that’s sounds stupid to you – that’s because it is!

So why does a US Fed Rate Move Matter?

The reason it matters is not so much the magnitude, but rather the fundamental change in perspective on what has been a long awaited shift. This will be a move that hasn’t happened since June 2006 and many economists in the world are calling for wide spread optimism as a result. The fact is that the US Federal Reserve has been calling for a rate increase for a very long time, and if it doesn’t happen soon it runs the risk of seeming like the boy who cried wolf. If you look below at how closely the US and Canadian 10-Year Bond Yields have correlated over the last ten years then one thing you know for certain is – there will be a widespread Canadian impact for any major change in US or world sentiments.

Expectations are rising for the Fed to raise rates in its next meeting in December … you may not want to bet against the influence of the US Federal Reserve on Canadian interest rates.

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