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19 Jul

Understanding what drives Variable rates and Fixed rates

Financial

Posted by: Garth Chapman

Your Variable Mortgage Rates are driven by your bank’s Prime Rate which is set individually by each Bank. They normally (but not always) move in sync with changes in the Overnight Rate, which is set by the Bank of Canada (BoC) and is used as a basis for one-day (or “overnight”) borrowing between the major lenders and financial institutions.

The BoC is responsible for monetary policy, the goal of which is to keep inflation near the mid-point of a 1 to 3 per cent target range, ideally 2%. The BoC is equally concerned with significant movements in the inflation rate, both above the 2% mid-point and below it. When demand is strong, it can push the economy against the limits of its capacity to produce. This tends to raise inflation above the midpoint, so the BoC will raise interest rates to cool off the economy. When demand is weak, inflationary pressures are likely to ease. The BoC will then lower interest rates to stimulate the economy and absorb economic slack.

So when the economy heats up and there is a threat that inflation could get beyond the 1 to 3 per cent target the BoC may increase the overnight rate, which drives the Prime Rate. The schedule of dates when the BoC reviews and sets the Overnight Rate is found here http://www.bankofcanada.ca/core-functions/monetary-policy/key-interest-rate/

Fixed Mortgage Rates are driven by the Bond markets. Typically, when bond rates (also known as the bond yield) go up, interest rates go up as well. And vice versa. Don’t confuse this with bond prices, which have an inverse relationship with interest rates.

Investors turn to bonds as a safe investment when the economic outlook is poor. When purchases of bonds increase, the associated yield falls, and so do mortgage rates. But when the economy is expected to do well, investors jump into stocks, forcing bond prices lower and pushing the yield (and mortgage rates) higher.

The spread between 5-year Government of Canada Bonds and 5-year mortgage rates varies within a range that has fluctuated in recent years. You can follow the 5-year Bond Yield in Canada on the BoC website here and you will notice that a period of Bond yield increases or drops will almost always be followed by a corresponding change in fixed rates for mortgages.