The recent surge in the yields of long-term bonds has pushed borrowing costs to levels not seen since before the 2008 financial crisis, squeezing homeowners, businesses and governments and reducing the odds of a soft landing for the Canadian economy.
Since the summer, bond markets have been roiled by stubborn inflation and a growing belief among investors that the Bank of Canada, the U.S. Federal Reserve and other central banks won’t be cutting interest rates any time soon. The shift in market sentiment sparked a sell-off in long-term bonds. This caused the spike in bond yields, which rise when prices fall.
In Canada, yields on 10-year government bonds have risen to 4.15 per cent, from 2.75 per cent six months ago. In the United States, 30-year treasury yields pushed above 5 per cent last week for the first time since 2007.
These moves could have a profound impact on the Canadian economy. Government bonds provide a reference point for all other borrowing costs. When benchmark yields rise, homeowners face bigger mortgage payment shocks and governments are forced to put more tax dollars toward interest payments. Sharp moves in bond markets can also pose risks to financial system stability.
Here are some of the areas being affected by the higher-for-longer mood that has overtaken markets.
Homeowners and the housing market
Interest rates on variable-rate mortgages have jumped over the past year and a half alongside Bank of Canada interest-rate hikes. Now rates on fixed-rate mortgages, which typically track five-year Government of Canada bond yields, are racing higher.
“The increase in the five-year yield this week implies that the lowest available five-year fixed mortgage rate could rise to 6.25 per cent or so, an increase of 150 basis points from April,” Stephen Brown, deputy chief North America economist at Capital Economics, wrote in a note to clients. That’s “equivalent to a hit to affordability of about 13 per cent,” he said. (A basis point is a hundredth of a percentage point.)
So far, less than half of all Canadian mortgage holders have seen their monthly payments increase since the Bank of Canada started raising rates in March, 2022. But that number will rise to around two-thirds by the end of next year and 85 per cent by the end of 2025.
The payment shocks implied by today’s bond market pricing could act as a significant drag on the Canadian economy, James Orlando, senior economist at Toronto-Dominion Bank, explained in an interview. “If you’re spending more money on just paying your housing bills, what are you going to do? Where are you going to cut?” he said.
Real estate activity is cooling rapidly as mortgage rates rise. Home sales have become much less frequent in major markets such as Toronto and Vancouver in recent months, and prices have started to fall. Mr. Orlando said this could feed through into home construction. “We know there’s a huge pipeline of needed housing ... but when house prices are going down, it’s hard to incentivize building,” he said.
Government finances
The rise in bond yields has major implications for federal and provincial government finances. This shift will increase the costs of borrowing new money, making deficits more burdensome. It will also push up debt-servicing costs, as outstanding bonds mature and need to be refinanced at higher interest rates.
In July, the federal government spent $3.85-billion on interest payments, up 23 per cent from a year before. This was the largest monthly payment in 27 years. Long-term bond yields have moved up by more than half a percentage point since then.
The federal government is now spending more than 10 per cent of its revenue servicing debt. That’s well short of the levels seen in the 1990s, when Ottawa was putting more than 30 cents of every dollar it collected toward interest payments. But it’s up from an average of around 7 per cent in the five years before the pandemic, and moving in the wrong direction.
“Since Ottawa’s debt rolls over only slowly ... these interest costs are poised to rise much further yet,” Bank of Montreal chief economist Douglas Porter wrote in a note to clients last week.
He noted that the federal government has just over $1.3-trillion in bonds and treasury bills outstanding. “At a 4.5 per cent interest rate (a blend between short and long-term rates), the monthly interest costs could eventually rise by another $1-billion,” he said.
Investors
Bond investors have taken a drubbing over the past two years as central banks have raised rates, pushing bond prices lower. In recent months, long-bond investors have been hit particularly hard, with FTSE Russell estimating that Canadian bonds with terms of more than 20 years have lost nearly 12 per cent of their value in the past three months.
The rise in bond yields is having a knock-on effect on stock prices. Higher borrowing costs eat into company profits and reduce the value of future earnings. Rising interest rates also make fixed-income products, such as bonds and GICs, more attractive compared with riskier stocks, reducing investor demand for equities. The S&P 500 index is down 3.2 per cent over the past month, while the TSX Composite Index is down 4.4 per cent.
The S&P 500 index “has already moved sideways for more than two years now as yields have risen off the floor, and it looks like valuations are still finding the new normal through some combination of price stagnation/declines and earnings growth,” Robert Kavcic, senior economist at BMO, wrote in a note to clients.
“For what it’s worth, Canadian stocks have been hit harder in recent months, leaving the yield spread and [price-earnings] ratio already cheaper than pre-financial-crisis norms.”
The financial system
Large and rapid moves in bond markets can lead to financial stability problems. This happened in Britain last year, when a sudden move in bond prices caught pension funds by surprise, forcing the Bank of England to intervene to prevent a fire sale in the gilt market. This spring, California-based Silicon Valley Bank failed after it was forced to sell part of its bond portfolio at a deep loss, sparking a run on the bank.
“A key lesson from history is that problems tend to emerge after large moves in asset prices (rather than when they surpass a particular level) and in corners of the financial system where there are large amounts of leverage,” Neil Shearing, chief economist with Capital Economics, wrote in a note to clients.
“With this in mind, it is perhaps of some comfort that the move in yields so far has been smaller than in the run-up to last year’s LDI crisis in the UK, and that financial sector leverage more generally is lower than in previous periods of systemic stress.”
In Canada, the Big Six banks are sitting on around $34-billion in unrealized losses in their fixed-income portfolios, Shokhrukh Temurov, DBRS Morningstar’s vice-president of financial institutions, said in an interview. But these paper losses remain small relative to total assets, and there is little indication that the banks would be forced to realize the losses, he added.
“It would be wrong if I said there is no risk at all, because there’s always a risk in banking. ... But, in Canada specifically, risk is quite low vis-à-vis the U.S., because of the fundamentals and the banking industry structure,” Mr. Temurov said.
Mark Rendell