How much higher are fixed rates over bond yields?
In a normal market, the average spread or markup of fixed mortgage rates above secured government bond yields is roughly 100 to 200 basis points, or 1% to 2% (there are 100 basis points in a percentage point).
Why not higher? Back to the word 'compete.' Banks need cash to operate but have to compete with other banks for investment. The nature of competition regulates rates and prices based on supply and demand. So competition keeps a leash on how much higher fixed rates should be.
What can impact the spread relationship?
Times of financial uncertainty can trigger 'mood swings' in the spread between 5-year bond yields and 5-year fixed rates. For example, in 2020, as Canadian markets were tossed around by the COVID-19 pandemic, some banks briefly raised their fixed mortgage rates despite bond yields falling (widening the spread) because lenders feared a pandemic-driven recession and the resulting defaults.
Or, the 5-year bond yields can experience sudden spikes as bond traders react to surprisingly high inflation numbers. For example, when sky-high inflation numbers were reported last June, bond yields rose rapidly with the assumption that more interest rate hikes were on the way, compressing the spread until fixed rates were bumped up accordingly, re-establishing the typical spread relationship.
How are bond yields influenced by the central bank's policy rate?
Through the 'anticipation' of it all. Bond traders trade bonds much like stockbrokers trade stocks — they try to anticipate where things are going to avoid potential risk. Stockbrokers buy and sell stocks in anticipation of a company's positive or negative announcement. And bond traders trade government bonds in anticipation of BoC rate announcements (if rates are forecasted to go up or down).
So, for example, if inflation news is unexpectedly bad, bond traders will bid up bond yields because they anticipate a rate hike by the central bank (keeping inflation under control is the institution's primary purpose). But if inflation comes in lower than expected, bond traders will bid down bond yields in anticipation of a prime rate cut. Fixed mortgage rates are therefore indirectly influenced by the central bank's policy rate as yield trends go higher or lower.
What about longer-term bond yields? Under normal market conditions, long-term yields tend to be higher than short-term yields to attract investment in 'the future.' If bond traders fear that inflation is out of control now, short-term bond yields are bid up (leading to higher fixed mortgage rates in the short term).
What is the risk of central bank rate hikes to tame high inflation? That a recession (economic contraction) may follow.
During a recession, central banks generally want to lower the prime rate to stimulate the economy. So, if bond traders expect a recession, they will trade down long-term bond yields (e.g. 10-year term) in anticipation of future prime rate drops — which can lead to a curve inversion between short and long-term yields.
Why watch 5-year bond yields, and not 4 or 6?
Or 3, or 2 — you get the idea. Banks use the 'standard' length of 5 years for setting other rates and prices, so it becomes the one to watch for simplicity's sake.
If you really want to get technical, 4-year bond yields are likely a closer index to watch. Why? Because even though a 5-year term is chosen, many mortgage holders end up only 'holding' it for an average of 4 years (3.89 years, actually). This average absorbs homeowners who find that they need to make a change before the end of their term — like refinancing or switching — because life happens.
(That's why we advocate for your best mortgage product with your best rate — to save more on hidden fees or higher penalties later if you need a change.)
The 5-year yield is a good indicator of the market trend, though the 4-year may show a tighter 'spread relationship' to better predict banks' timing on rate moves.
The bond bottom line
Bonds trade perpetually (during exchange hours), which means 5-year fixed mortgage rates can move at any time.
And while they don't move in lockstep with bond yields, keeping an eye on the spread relationship may help you determine where fixed rates may be headed, and give you a slight thrill when you do see banks move rates as bond yields go up or down.