Our economy seems relatively healthy, but let’s not forget how sensitive it is.

The Government of Canada and the Bank of Canada have been carefully working to strengthen our Canadian economy throughout this economic crisis. At the inception we saw a commitment from the Bank of Canada to keep interest rates low. Now that our housing market is over heating, we are met with media dominating press releases from the Minister of Finance, telegraphing a desire to slow down the red hot housing market and the rate at which Canadian homeowners are harnessing the debt in their homes.

Many economists are calling for immediate and sizeable increases in the Bank of Canada’s Overnight rate and therefore the prime rate that your mortgage is tied to.

After seeing the careful and methodical approach our Central Bank and Finance Ministry have taken in response to this economic crisis in Canada I do not believe that we will see the immediate and sizeable interest rate increases many economists are calling for.

This does not mean that interest rates will not increase. With each positive Canadian economic report related to jobs and growth that we see, Canadian Bond yields will increase thereby putting pressure on fixed rate mortgages across the board (please click here for a quick explanation as to how bond yields affect mortgage rates). It must however be noted that increasing interest rates will have a negative affect on the real estate market. More importantly it will reduce our exports to the United States, further cutting into Canadian employment, which I am sure our politicians will be careful to minimize.

There is only one key factor that would allow for more rapid and dramatic increases in Canadian interest rates: The American Economy. If we see significant signs that the American economy is recovering from the pronounced recession that it is in Canadian policymakers will be able to increase the overnight rate and satisfy all of the economists who believe that a wave of inflation will overwhelm our economy.  We would caution against betting the farm on an immediate American recovery. Without a massive advance in technology or a level of efficiency in US Government spending never before seen it is unlikely that the American economy will recover for some time.

Strategy Going Forward

We believe that the prime rate will increase on July 20th of this year or slightly thereafter. This increase will be no more than 0.50% (more likely 0.25%) and will result in a significant increase in the relative price of the Canadian dollar.

With 5 year fixed rates staying within a range of 3.5% to 5.5% for the medium term and the Prime rate possibly increasing by 1% to a maximum of 2% over the medium term we will continue to advocate staying flexible with your mortgage. Although our 5 year fixed rate is low and extremely competitive try to stay variable or go into short term fixed rate mortgages. Variable rates are as low as 1.85% which is 0.40% below prime, and 1 year fixed rate mortgages are around 2%. With a trend towards lower variable rate mortgage premiums you will be well served in 1 year fixed rate mortgages or shorter term variable rate products. This will allow you to take advantage of the continued economic uncertainty in 2010 and 2011, and provide an opportunity for you to lock into more discounted variable rates in the future (for our current Mortgage Strategy Report please click here).
A Government bond is a financial instrument with a fixed rate of return that can be bought and sold freely on the open market.

For purposes of simplicity let’s use an example.

A bond costs $100 and earns 5% interest annually. That 5% is paid to the holder of the bond at the end of the year. If interest rates rise the sellers of bonds will realize that they will need to offer more money to people in exchange for buying their bonds in order to compete with higher interest rate returning alternatives. This increase in the interest paid out on new bonds being issued results in a decrease in the price of the older bonds to ensure that they stay competitive. If comparable market interest rates reach 7%, the 5% bonds will now be offered for sale at around $98. The reduction in price increases the yield on the bond.

Since mortgages are just like bonds they will increase in rate as interest rates appear to be increasing.

When bond prices increase, their yields decrease and so to do mortgage rates. When bond prices decrease, their yields will increase and so will mortgage rates.

If investors expect interest rates will drop due to slow economic growth they are willing to invest their money in bonds with relatively low rates of return, once investors see an economy growing and expect interest rates to rise they will sell bonds with low rates of return, this will reduce bond prices and increase their yields.