Download Mortgage Interest Rates

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