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May 2012 Note: This article deals with a complex topic and does not claim to examine all angles of this subject exhaustively. Rather, it attempts to present the key issues. Market Analysis Department © 2012 Québec Federation of Real Estate Boards. All rights reserved. Table of Contents Historically Low Interest Rates ......................................................................................................... 1 Main Determinants of Fixed Mortgage Rates: An Overview .......................................................... 2 Cost of Funds ................................................................................................................................................... 2 Spread Between the Cost of Funds and the Mortgage Rate ............................................................................. 3 Structural Factors Contribute to Low Mortgage Rates ................................................................... 6 The Framework of Canada’s Monetary Policy Reduces Inflation Premium ...................................................... 6 Disciplined Management of Canadian Public Finances: Efforts That Have Paid Off .......................................... 7 Cyclical Factors Also Contribute to Historically Low Mortgage Rates ......................................... 8 Sluggish Economic Conditions ......................................................................................................................... 8 Canadian Bonds: A Safe Haven in an Unstable Global Economy ................................................................... 11 Conclusion........................................................................................................................................ 14 Charts Chart 1 The average rate for five-year term mortgages recently fell below 5 per cent for the first time since 1951 ............................................................................................................ 1 Chart 2 Five-year mortgage rate is strongly correlated with government bond yields of the same maturity ...................................................................................................................... 3 Chart 3 The spread between bond yields and mortgage rates remains relatively stable except in periods of strong economic and financial uncertainty ........................................... 4 Chart 4 The inflation premium is an important component of interest rates in general, including mortgage rates ................................................................................................................ 6 Chart 5 Canada’s financing needs have been greatly reduced since the mid-1990s .................................. 8 Chart 6 Moderate inflation expectations since the outbreak of the financial crisis ...................................... 9 Chart 7 The yield on long-term financial securities followed the decrease in the yield on shorter-term securities .......................................................................................... 10 Chart 8 Canadian bond yields followed that of falling U.S. bonds ............................................................. 11 Chart 9 The Canadian bond market attracted a record amount of foreign capital since the outbreak of the 2008 financial crisis ....................................................... 12 Chart 10 The sovereign debt crisis in Europe led to higher bond yields for countries at risk ....................... 13 Boxes Box 1 Main Components of the Mortgage Rate .................................................................................. 5 Box 2 Main Structural and Cyclical Factors That Explain the Decrease in Mortgage Rates in Canada..................................................................................................... 15 Structural and Cyclical Factors That Explain Low Mortgage Interest Rates 1. Historically Low Interest Rates Mortgage rates have been following a downward trend in the past few years to reach today’s historically low level, falling for the first time below 5 per cent for a five-year term1. In March, the average mortgage rate charged2 in Canada for a five-year term reached its lowest level since January 1951, at only 4.21 per cent. Since the mid-1990s and, more specifically, the start of the “Great Recession3”, interest rates have contrasted sharply with those observed in the 1970s and 1980s. Interest rates in general, and mortgage rates more specifically, had peaked at well over 10 per cent and even 20 per cent in the early 1980s (see chart 1). Why have mortgage rates recently fallen to this historically low level? What are the factors that put, or are currently putting, downward pressure on mortgage rates in Canada? Are Canada’s low mortgage rates simply a reflection of sluggish economic conditions, or can they also be explained by more structural factors? In March, the average mortgage rate charged in Canada for a fiveyear term reached its lowest level since January 1951, at only 4.21 per cent. Source: Canada Mortgage and Housing Corporation (CMHC) 1 2 3 In Canada, data on the average mortgage rates charged for a five-year term only begins in January 1951. The average mortgage rate charged corresponds to the average of mortgage rates that are actually granted. This should not to be confused with the administered rate, which is the rate posted by financial institutions. A few months after the economic crisis broke out, the average fixed-rate mortgage for a five-year term in Canada fell from 6.51 per cent in November 2008 to 4.62 per cent in May 2009, a decrease of 189 basis points in just six months, according to the Bank of Canada. 1 Structural and Cyclical Factors That Explain Low Mortgage Interest Rates 2. Main Determinants of Fixed Mortgage Rates: An Overview While movements in variable mortgage rates are mainly influenced by the Bank of Canada’s key interest rate, changes in fixed mortgage rates are the result of the complex combination of several factors. In general, there are two main components that can influence fixed mortgage rate levels (see box 1). Cost of Funds The first component is the cost of funds that financial institutions use to finance the mortgage loans they provide. These funds come primarily from deposits made by savers5. As they are guaranteed by the government6, these deposits are considered a very safe type of investment and must provide a competitive remuneration compared to Government of Canada bonds, which are a similar financial product used as a reference. The other part of the funds7 is borrowed from the mortgage bond market, where investors buy financial securities (in this case, bonds) backed by insured mortgages8. These mortgage bonds are financial securities guaranteed by the Canadian Government9. They are therefore a similar financial product to Government of Canada bonds, in terms of liquidity (highly liquid market) and default risk (both guaranteed by the Canadian Government and rated AAA by major rating agencies). Changes to yields in the mortgage bond market depend on essentially the same forces that are at play on the government bond market. Finally, changes in the cost of funds used by financial institutions to make mortgage loans are therefore similar to changes in the yield of Canadian Government bonds, as evidenced by the almost perfect positive correlation between mortgage rates and bond yields of similar maturity10 (see chart 2). 4 5 6 7 8 9 10 4 While movements in variable mortgage rates are mainly influenced by the Bank of Canada’s key interest rate, changes in fixed mortgage rates are the result of the complex combination of several factors. Changes in the cost of funds used by financial institutions to make mortgage loans are similar to changes in the yield of Canadian Government bonds, as evidenced by the almost perfect positive correlation between mortgage rates and bond yields of similar maturity. For more information on this topic, read the February 2011 Word From the Economist “Factors That Determine Mortgage Rates in Canada”. According to the Canada Mortgage and Housing Corporation (CMHC), in 2010 more than half (58.9 per cent) of the funds used to finance the mortgage market came from deposits made to financial institutions (primarily guaranteed investment certificates and other term deposits). The Canada Deposit Insurance Corporation (CDIC), a federal Crown corporation, insures up to $100,000 of most deposits (chequing and savings accounts, guaranteed investment certificates and other term deposits with a maturity of five years or less) made at Canadian financial institutions that are members. Also according to the CMHC, the covered and guaranteed mortgage bond market provided about 31 per cent of the funds used to finance the mortgage market in Canada in 2010. The remaining financing came from deposits (see note 6), private securitization (which decreased significantly following the subprime crisis), as well as funds from trust companies, mortgage lenders, life insurance companies, pension funds and institutions that do not accept deposits. The mechanism described here is that of public securitization. This refers to the issuing of bonds backed by pools of residential mortgages insured by the CMHC or private insurers. Private securitization, which fell sharply in Canada after the subprime crisis broke out, is based on uninsured mortgages. The guarantee is either directly on the bond itself (as with the two CMHC securitization programs: the National Housing Act Mortgage-Backed Securities Program and the Canada Mortgage Bonds Program), or indirectly (mortgages associated with the bond are guaranteed as in the case of covered bonds). The correlation coefficient between the yield on five-year Government of Canada bonds and the fixed mortgage rate of the same maturity is 0,98. This therefore means that both variables evolve in a very similar manner. 2 Structural and Cyclical Factors That Explain Low Mortgage Interest Rates Sources: Bank of Canada and CMHC Spread Between the Cost of Funds and the Mortgage Rate The spread between the cost of funds and the mortgage rate is the second component of the mortgage rate. This spread represents the return required by financial institutions to make funds available on the mortgage market. It is primarily a reflection of three elements: the cost of operating and negotiating the loan11; a premium related to the risk of default which, as its name suggests, offsets risk-taking based on the borrower’s probability of default during the loan period12; and finally, the profit margin required by the financial institution. In the long term, the difference between the yield on five-year Government of Canada bonds (which is the benchmark for measuring the cost of capital used to finance mortgage loans) and the average five-year mortgage rate appears rather stable in Canada. In general, it hovers at around 200 basis points, except in periods of strong economic and financial uncertainty like in the early 1980s during the implementation of an extremely strict monetary In the long term, the difference between the yield on five-year Government of Canada bonds and the average five-year mortgage rate appears rather stable in Canada. In general, it hovers at around 200 basis points. 11 This cost includes administrative fees, management fees, securitization fees, hedging and marketing fees, etc. 12 In Canada, mortgage insurance, which covers a vast majority of Canadian mortgage loans since 1954, guarantees and protects investors from the risk of default. However, this insurance does not include the disappearance of additional costs associated with a default (recovery, late fees, etc.) that are often incurred by the financial institution. To account for these costs, the financial institution charges a premium that is calculated according to the borrower’s level of default risk. 3 Structural and Cyclical Factors That Explain Low Mortgage Interest Rates policy aimed at ending stagflation13 or in late 2008 when the subprime crisis broke out in the United States (see chart 3). This component of the mortgage rate does not seem to provide an indication of why mortgage rates have fallen recently. In fact, recent changes in the spread between the cost of funds and the mortgage rate should have led to an increase in mortgage rates, as the risk premium has increased sharply since the start of the crisis. For this reason, we will focus primarily on identifying the different structural and cyclical factors 14 that help to explain changes in the main component of mortgage rates: the cost of funds used to finance mortgage loans. Sources: Bank of Canada, CMHC, QFREB calculations. 13 Stagflation is an economic situation that was observed in the 1970s and early 1980s in developed countries. It is characterized by low economic growth (stagnation) and high inflation. 14 Factors other than those presented in this document that may have an influence on interest rates were not discussed due to their relatively small impact. More specifically, these include changes in the exchange risk premium, which aims to compensate foreign investors for any loss due to fluctuations in exchange rates. With financial markets becoming increasingly integrated, the exchange risk premium has become, for some countries, a significant component. In Canada, however, we consider that the impact of the exchange risk on the level of interest rates is currently low due mainly to the relative stability of Canadian currency. 4 Structural and Cyclical Factors That Explain Low Mortgage Interest Rates Box 1 - Main Components of the Mortgage Rate Institution’s profit margin Operating and negotiation costs Default risk premium Mortgage rate Liquidity premium Total cost of funds made available on the mortgage market by financial institutions Maturity premium Cost of reference (i.e., remuneration of investors by the financial institution) Inflation premium Real risk-free rate Clarifications: The real risk-free rate reflects the minimum remuneration required by an economic agent in order to incite them to invest their money rather than use it for consumption purposes (i.e., compensates the loss of satisfaction associated with the release of immediate consumption). As its name suggests, this component of the mortgage rate does not take risk into account, be it related to the borrower’s ability to pay back or price changes. The inflation premium is intended to compensate for potential losses arising from price changes and guarantee a real return to investors. The real riskfree rate plus the inflation premium is the risk-free nominal rate. The liquidity premium is the compensation associated with the immobilization of capital during a given period. The maturity premium is designed to compensate for the risk associated with uncertainties regarding changes in economic conditions during the remaining term of the loan. The default risk premium is based on estimating the probability of default by the borrower. With regard to the mortgage rate, one part of this premium aims to protect investors from default by the Government of Canada, who guarantees the mortgages. Note that even though the Government of Canada is not infallible in the long term, this premium is negligible for maturities of short- and medium-term. The other part of the premium, which is generally more important, aims to cover mortgage lenders who will incur the costs in the event of default (fees associated with a late payment or a failure in payment, foreclosure procedure, etc.) even if the loan is guaranteed by the government. Finally, operating and negotiation costs include administrative fees, management fees, marketing and securitization fees, etc. Note: The size of the elements in this diagram are not representative of the proportion of each component of the mortgage rate. 5 Structural and Cyclical Factors That Explain Low Mortgage Interest Rates 3. Structural Factors Contribute to Low Mortgage Rates Since the mid-1990s, structural factors affecting capital markets have contributed to the long-term decrease of interest rates in general, including mortgage rates. The Framework of Canada’s Monetary Policy Reduces Inflation Premium The inflation premium, which aims to offset the yield for the loss of purchasing power due to an increase in prices, is an important determinant in the cost of funds (see box 1). In the 1970s and 1980s, increases in consumer prices were such that investors demanded a very high inflation premium (see chart 4). The inflationary environment in the 1970s and 1980s was therefore largely responsible for high interest rates. The inflationary environment in the 1970s and 1980s was largely responsible for high interest rates. Announcement of the adoption of a monetary policy for inflation-control targeting in 1991, by the Bank of Canada. Sources: Statistics Canada and CMHC. Thus, beginning in 1991, the Bank of Canada adopted a monetary policy for inflation-control targeting. It is one of the two main structural factors that contributed to the lowering of interest rates in Canada. This essential component of the monetary policy framework aims at maintaining the inflation rate at around 2 per cent, the mid-point of a 1 to 3 per cent target range15. It thereby guarantees some stability in price changes and reduces uncertainty 15 The target range of 1 to 3 per cent was explicitly established in 1993. 6 Structural and Cyclical Factors That Explain Low Mortgage Interest Rates surrounding inflation. Ultimately, the Bank of Canada’s adoption of this monetary policy framework contributes to the decrease in Canadian mortgage rates by reducing the inflation premium, which is one of the components of bond yields and mortgage rates (see box 1). Disciplined Management of Canadian Public Finances: Efforts That Have Paid Off The disciplined management of the Canadian debt that was implemented by the federal government in the mid-1990s has also had a lasting impact on Canadian bond yields and mortgages. By significantly and consistently reducing the debt burden in relation to the GDP between 1995 and 200716, the Government of Canada has sharply reduced its financing needs in relative terms (e.g. in relation to the GDP) and in absolute terms (there was a decrease in total outstanding loans and securities issued by the Canadian Government between the first quarter of 1997 and the first quarter of 2008 – see chart 5). On the one hand, this lower financing requirement by the federal government resulted in a decrease in the supply of government bonds, pushing their price up and their yield down17. On the other hand, this sustained reduction in Canada’s financing needs, which has freed up capital, has also resulted in an increase in demand for securities on other financial markets (particularly the mortgage bond market, which offers a similar level of risk to government bonds) and has thus contributed to a decrease in yields18 as well as mortgage rates. Moreover, even though the Canadian Government’s financing needs increased with the crisis that began in 200819, the disciplined management of Canada’s public finances in the economic environment of the past few years led the flight-to-quality phenomenon, that causes the bond market to act like a refuge for investors20, to be more specifically directed to the market of Government of Canada bonds. Thus, by demonstrating since the mid-1990s that it was able to ensure a disciplined management of its public finances, Canada has earned a certain credibility among investors, who in times of economic uncertainty, (whether it be on different stock markets around the world or on the European sovereign debt market as was recently the case) 16 17 18 19 20 By demonstrating since the mid-1990s that it was able to ensure a disciplined management of its public finances, Canada has earned a certain credibility among investors, who in times of economic uncertainty, consider the Canadian Government backed bond market one of the safest investments and therefore increase their demand for these securities. According to the OECD, Canada’s central government debt as a percentage of the GDP fell from 58.6 per cent in 1995 to 25.2 per cent in 2007, one of the lowest levels among developed countries. The yield and price of a bond are inversely related. Suppose you buy a five-year bond, at original issue, for $1000 and suppose the bond pays a coupon of 4% per year (you receive $40 during five years). The yield of this bond is then 4 per cent ($40/$1000). Suppose now that the price of the bond drops to $950. The yield, for the person buying at $950, jumps to 4.21 per cent ($40/$950). Therefore, when the price of a bond increases, its yield (i.e., its rate) decreases and vice-versa. See previous note. According to the OECD, Canada’s central government debt as a percentage of the GDP grew from 25.2 per cent in 2007 to 36.1 per cent in 2010. This increase in the need for financing arose from Canada’s increased debt, which was caused by the crisis that resulted from an increase in public spending and a decrease in government revenue. This increase in the need for capital in the bond market therefore favoured an increase in Canadian bond and mortgage yields. However, this effect did not offset the downward pressure from the increased demand in the market for bonds backed by the Canadian government resulting from uncertainty on other capital markets in Canada and around the world which, ultimately, translated into a decrease in mortgage rates. In periods of strong economic uncertainty, such as the one we have been experiencing since the outbreak of the subprime crisis in the United States in 2008, investors tend to favour the government bond market in order to protect themselves from too high a risk, as may be the case with the stock market. At the start of the crisis, the sharp drop in the Standard and Poors (500) Index, which fell from 1,282,83 points in August 2008 to 735 points in February 2009, reflects this mistrust in stock markets. 7 Structural and Cyclical Factors That Explain Low Mortgage Interest Rates Sources: Statistics Canada and QFREB calculations. consider the Canadian Government backed bond market one of the safest investments and therefore increase their demand for these securities, thereby lowering their rate of return21. 4 Cyclical Factors Also Contribute to Historically Low Mortgage Rates While we’ve seen how certain structural factors contribute to a sustained decrease in mortgage rates, other factors that are more cyclical in nature also contribute, this time temporarily, to the decrease in interest rates in general, including mortgage rates. Over the past three years, several factors related to current and anticipated changes in the economic conditions and financial instability have contributed to the decrease in yields on the Canadian mortgage bond and government bond markets. Sluggish Economic Conditions First, Canada’s slowdown in economic growth and more pessimistic outlook regarding the economy led to lower inflation expectations. Because a part of bond yields is designed to compensate for the inflation risk in order to ensure investors of some real returns (e.g. offsetting the effect of price changes), the decrease in inflation expectations has helped to exercise downward pressure on bond yields. As evidenced by changes in implicit inflation, which is an indicator of inflation expectations by financial markets (obtained by calculating the 21 See note 17. 8 Structural and Cyclical Factors That Explain Low Mortgage Interest Rates difference between the yield of long-term bonds and that of long-term real return bonds22), inflation expectations fell sharply after the financial crisis broke out in the summer of 2008, falling from 2 per cent in June 2008 into negative territory (reflecting the anticipation of deflation) between November 2008 and March 2009, before increasing slightly to fluctuate at its current level of approximately 1 per cent (see chart 6). The decrease in inflation expectations has helped to exercise downward pressure on bond yields. Fall 2008: Outbreak of financial crisis Sources: Bank of Canada and QFREB calculations. In addition, poor prospects for Canada’s economy pushed the Bank of Canada to conduct an unprecedented “expansionary” monetary policy, keeping its key interest rate at the rock-bottom rate of 0.25 per cent between April 2009 and May 2010 and at a very low level even today (1 per cent) in order to stimulate the Canadian economy in the short term. This strongly expansionary monetary policy, conducted for an extended period of time and anticipated by financial markets, has caused a change in investors’ preferences (portfolio effect) as they began to favour longer-term securities with higher returns, such as five-year government bonds for example (see chart 7). This increase in the demand for longer-term bonds led to an increase in prices on the bond market which translated into a decrease in long-term bond yields23. Poor prospects for Canada’s economy pushed the Bank of Canada to conduct an unprecedented “expansionary” monetary policy, keeping its key interest rate at the rock-bottom rate of 0.25 per cent between April 2009 and May 2010 and at a very low level even today (1 per cent) in order to stimulate the Canadian economy in the short term. 22 Unlike nominal bonds, real return bonds offer a yield that is adjusted according to changes in the Consumer Price Index (CPI). 23 See note 17. 9 Structural and Cyclical Factors That Explain Low Mortgage Interest Rates Normally, this decrease in long-term yields due to a growing demand for long-term securities is offset, at least in part, by an increase in the inflation premium (see box 1). This increase occurs in order to offset the price increases that are expected following the anticipated return to economic growth fueled by the implementation of an expansionist monetary policy (Fischer effect). However, after the 2008 financial crisis, the scope and persistence of economic problems, particularly in the United States and Europe, left little hope for a quick return to strong and lasting economic growth. Inflation expectations therefore rose, but in a more moderate manner, to vary at approximately 1 per cent (see chart 6), thereby limiting the increase in inflation premium that should have theoretically been observed with long-term bond yields. Source: Bank of Canada. Finally, the weak economic recovery in the U.S. and the use of unconventional monetary policies, among others, through quantitative easing measures24, resulted in a significant decrease in long-term yields in the United States. The increase in the spread between Canadian and American government bond yields led to a massive influx of capital on the Canadian bond market, which offered a higher return. Thus, the net flow of transactions on the Canadian bond market by American investors reached a new record in May 2009 with a total of C$17.3 billion in only one month, a 12 per cent increase compared to the previous record set in October 2001 following the 24 The increase in the spread between Canadian and American government bond yields led to a massive influx of capital on the Canadian bond market, which offered a higher return. Quantitative easing is an unconventional monetary policy characterized mainly by the acquisition of financial assets by a central bank. It thus puts money in circulation into the economy by increasing bank reserves in order to encourage them to extend new loans. It is used when more traditional methods, such as decreasing the key interest rate, do not appear to be sufficient and/or when there is a liquidity crisis. During the recent financial crisis, this quantitative easing policy was implemented by the U.S. Federal Reserve, by the European Central Bank and by the Bank of England. 10 Structural and Cyclical Factors That Explain Low Mortgage Interest Rates September 11 attacks. In total, the net flow25 of transactions on the Canadian bond market by American investors between January 2009 and February 2012, reached nearly C$183 billion26. This significant and unprecedented increase in U.S. investment on the Canadian bond market therefore contributed in pulling Canadian bond yields downward (see chart 8). Sources: Federal Reserve Bank of Saint Louis and QFREB calculations. Canadian Bonds: A Safe Haven in an Unstable Global Economy The decrease in bond yields was reinforced by the flight-to-quality phenomenon, which also contributed to the massive influx of capital on the bond market with its very low risk level (such as mortgage bonds or government bonds) compared to stock markets in particular. This growing aversion to risk translated into a sharp increase in demand for bonds, pushing bond prices up and their yields down27. Moreover, this influx of capital on the Canadian bond market was reinforced by major budget problems that some countries in the Euro zone experienced after the outbreak of the sovereign debt crisis. This crisis raised fears of debt default by many European countries and forced investors to turn to countries with a more sound financial situation, such as Canada. As a result of this flight-to-quality phenomenon, the net flow of international The influx of capital on the Canadian bond market was reinforced by major budget problems that some countries in the Euro zone experienced after the outbreak of the sovereign debt crisis. This crisis raised fears of debt default by many European countries and forced investors to turn to countries with a more sound financial situation, such as Canada. 25 This takes into account the new issuing and redemption of bonds, the sale and purchase of outstanding series and the change in interest payable. 26 Sources: Statistics Canada and QFREB calculations. 27 See note 17. 11 Structural and Cyclical Factors That Explain Low Mortgage Interest Rates operations in Canadian bonds set a new record in 2010 at $96.1 billion, eight times more than the $12 billion registered in 2007. This influx also reached very high levels in 2009 and 2011, at $84.6 billion and $44.2 billion, respectively (see chart 9). Source: Statistics Canada. The European debt crisis thus led to an increase in risk premium in countries considered at-risk such as Greece, Ireland and Portugal. For the time being, this increase came later and more moderately in Italy and Spain, benefitting countries with a more reassuring public finance situation such as Germany, France and Canada (see chart 10). Ultimately, the outbreak of the 2008 financial crisis caused a lot of movement on financial markets, leading to a significant portfolio effect, meaning a change in the type of financial investments favored by investors (short, medium and long-term maturities, moderate or high level of risk, etc.), which resulted in a massive influx of capital on the Canadian bond market in particular. As we just saw, this portfolio effect has taken on three main dimensions in recent years: a temporal dimension, with the movement of capital from short-term securities to the benefit of better paying long-term The outbreak of the 2008 financial crisis caused a lot of movement on financial markets, leading to a significant portfolio effect that resulted in a massive influx of capital on the Canadian bond market, making mortgage financing increasingly accessible. 12 Structural and Cyclical Factors That Explain Low Mortgage Interest Rates securities; a geographic dimension, with the movement of capital from the United States to Canada; and finally, a risk dimension, with the movement of capital from a very volatile and uncertain stock market to a more stable bond market as well as from a European market affected by the sovereign debt crisis to countries with more stringent requirements in terms of public finances. These three dimensions of the portfolio effect, by acting simultaneously and continuously, have contributed to an unprecedented increase in demand on the Canadian bond market, making mortgage financing increasingly accessible. Sources: OECD and central banks 13 Structural and Cyclical Factors That Explain Low Mortgage Interest Rates Conclusion The decrease in Canada’s mortgage rates in recent years is mainly due to a decrease in the cost of funds used to finance mortgage loans. The decrease was so significant that, despite an increase in the risk premium associated with difficult and uncertain economic conditions in recent years, mortgage rates still fell to historically low levels. The combination of two types of factors contributed to this decrease (see box 2). On the one hand, cyclical factors, such as weak economic growth in Canada, in the United States and around the world, stock markets deemed too risky, or the outbreak of the sovereign debt crisis in Europe, contributed (and continue to contribute) to reducing the cost of funds used by Canadian financial institutions to offer financing on the mortgage market. On the other hand, structural factors, such as inflation targeting which was adopted as the cornerstone of the Bank of Canada’s monetary policy as well as fiscal consolidation policies, and a relatively prudent management of public funds by the Canadian Government since the 1990s, have contributed to the long-term decrease in interest rates in Canada, including mortgage rates. Ultimately, Canadian mortgage rates should continue to remain close to their current level, as long as cyclical factors, which have an impact on interest rates, do not experience a significant and strong improvement. Recently, even if certain signs seemed to indicate that the flight-to-quality phenomenon was beginning to ease considerably (best quarter since 1998 on Wall Street in the first three months of 2012 and acquisition of Canadian bonds by non-residents amounting to only $1.9 billion in January 2012), significant doubts still weigh on the solidity of economic growth (in the United States particularly) and on the financial situation of certain European countries (such as Spain, which recently saw the rate for its 10-year bonds surpass the 6 per cent level once again, and Greece, which is facing major political challenges following parliamentary elections on May 6 that amplified uncertainty surrounding the country’s ability to undertake the reforms needed to restore its public finances). Last February, the acquisition of $13.7 billion in Canadian securities by foreign investors (mainly federal government bonds), the largest monthly investment since May 201028, suggests that the flight-to-quality phenomenon remains important. In the longer term, Canadian mortgage rates should gradually increase as the economy recovers (e.g. better yields on stock markets and in emerging countries that would blur the flight-to-quality phenomenon, accelerated growth in Canada and increase in inflation expectations), while remaining relatively low due to structural factors29. On the one hand, cyclical factors, such as weak economic growth in Canada, the United States and around the world, stock markets deemed too risky, or the outbreak of the sovereign debt crisis in Europe, contributed to reducing the cost of funds used by Canadian financial institutions. On the other hand, structural factors, such as inflation targeting and fiscal consolidation policies, have contributed to the longterm decrease in interest rates in Canada, including mortgage rates. In the longer term, Canadian mortgage rates should gradually increase as the economy recovers while remaining relatively low due to structural factors. 28 Source: Statistics Canada. 29 On this topic, it is important to emphasize that the presence of structural factors does not mean that bond yields will not increase; rather, despite an improvement in cyclical factors that could exert upward pressure, rates will recover but will remain at a level that is lower than what would be observed if these structural factors were not present. 14 Structural and Cyclical Factors That Explain Low Mortgage Interest Rates Box 2 - Main Structural and Cyclical Factors That Explain the Decrease in Mortgage Rates in Canada Rigorous management of Canada’s public finances Relative decrease in the government of Canada’s financing needs Adoption of a very expansionary monetary policy by central banks Decrease in supply of government bonds on the Canadian market Increase in demand on other capital markets (particularly the Canadian mortgage bond market) Monetary policy for inflation-control targeting “Great Recession” Increased uncertainty about economic outlook Volatility on stock markets Decrease in yields of short-term financial securities and yields in the United States Slowdown in Canadian growth Outbreak of the European debt crisis Flight-to-quality phenomenon on capital markets Increased demand on the Canadian bond market Temporary decrease in inflation expectations Durable decrease in inflation expectations Decrease in inflation premium on bond markets Decrease in bond yields in Canada* Decrease in the cost of funds used to finance mortgage loans Legend Structural factors Decrease in mortgage rates Cyclical factors Contributes to * See note 17 on page 7 of this document. 15