Mortgage Rate Thaw Renews Housing Bubble Concern: Canada Credit

The bond market is suggesting an overheated Canadian housing market is about to get even hotter just in time for the spring thaw.

Five-year bond yields, which serve a benchmark for mortgage loans, are at a record low. Anticipation of increased lending has helped push the cost to hedge mortgage loans by banks to the highest level since August 2013, when frenzied activity in the housing market prompted authorities to clamp down.

With oil prices depressed to 5 1/2 year lows and both the International Monetary Fund and the World Bank cutting growth forecasts this month, traders have pushed out expectations for when central banks in the U.S. and Canada will raise benchmark interest rates. That’s caused the wholesale rates available to banks in the bond market to fall before the country’s traditional spring home-buying season.

“Real estate, it has nine lives,” said Benjamin Tal, deputy chief economist at Canadian Imperial Bank of Commerce, by phone from Toronto. “Every time it’s supposed to slow down because of interest rates, something bad happens elsewhere that keeps interest rates low. That’s exactly what we’re seeing now.”

The average five-year mortgage rate in Canada is a record-low 4.79 percent, according to central-bank data. Lower rates can be obtained from banks and other private lenders.

Policy Meeting

A month ago, traders were pricing in an 83 percent chance the Federal Reserve would raise the key U.S. rate by the end of 2015, according to Bloomberg calculations based on overnight index swaps. The chances today were 68 percent.

The Bank of Canada unexpectedly cut its benchmark interest rate to 0.75 percent today, from 1 percent, saying the oil slump will weigh on everything from inflation to business spending. It was the bank’s first rate reduction since 2009.

The gloomy outlook has increased demand for bonds, pushing the yield on five-year debt from the Canadian government to a record-low 0.786 percent.

At the same time, the cost for the securities banks use to hedge mortgage liabilities, the five-year swap spread, has risen.

The premium banks must pay over five-year government securities for a five-year interest rate swap -- the rate to exchange floating- for fixed-interest payments -- climbed as high as 46 basis points this month.

Anticipating Hedging

“The banks aren’t hedging yet, but other investors are anticipating the hedging activity and they’re basically front-running the banks,” said Ruslan Bikbov, a fixed-income strategist in New York at Bank of America Corp. “Mortgage rates, basically they have to decline.”

With consumer debt including mortgages at a record level and real estate valuations still rising, Canada’s situation today echoes the summer of 2013, when the nation’s housing agency rationed guarantees on mortgage-backed securities to help keep the market from becoming a bubble. That March, then-Finance Minister Jim Flaherty, who had already tightened mortgage rules, rebuked Bank of Montreal for reducing its five-year mortgage rate below 3 percent.

At the time, the benchmark five-year rate was 1.3 percent.

“This spring, in both the investment season and in the mortgage season, we hope to again have a fresh offer that is appealing to customers,” William Downe, chief executive officer of Bank of Montreal, said at Jan. 14 conference in Toronto. “And so in that sense, it isn’t a question of competing on price. It’s a question of competing on value.”

Housing Surge

Housing prices have continued to gain across the country, particularly in the largest cities. In Vancouver, the average home price jumped 27 percent since December 2008, according to the Canadian Real Estate Association. Toronto home prices rallied 49 percent in the same period to C$521,300 ($430,329) in December 2014.

This year, there’s no guarantee the banks will respond to the lower rates in the bond market by lowering mortgage rates, and even if they do, there’s no guarantee cheaper mortgages will further inflate housing values, according to CIBC’s Tal.

His own research shows an estimated 30 percent to 40 percent of Canadian households are taking advantage of low interest rates to pay back their mortgages to shorten their amortization, reducing the risk of an interest-rate shock.

Last month, the Bank of Canada said housing prices are overvalued by as much as 30 percent, posing an “elevated” risk to the domestic financial system.

“If we borrow more, that will add to the ultimate adjustment,” Tal said. “But that depends on what we do. We have seen in the past that Canadians use low interest rates to actually pay down debt faster, as opposed to add to their debt. If that’s what we do, it’s a good thing.”

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