Canadians accustomed to cheap money are quickly realizing that the era of rock-bottom rates could soon be coming to a close.
Since the worst of the financial crisis, government interest rates in Canada and the United States have remained exceptionally low, and for the past three years government bond yields have kept falling to shocking depths, with the five-year Government of Canada bond dropping once again to below 1.2 per cent in early May.
Since then, however, there's been a sudden turn.
Although the upswing in yields was anticipated, the feverish pace of this rise wasn't. Since the beginning of May, the yield on 10-year U.S. Treasuries has spiked roughly 60 basis points, or 0.6 per cent, to hit 2.5 per cent, their highest rate since August, 2011. (A basis point is 1/100th of a percentage point.)
These yields affect many parts of the economy, from residential mortgage rates to the values of Canadians' pensions. The sudden jump has caught many off guard. In the past month Royal Bank of Canada has already raised mortgage rates twice.
Bond yields began rising in early May when U.S. jobs numbers came in much better than expected, and then they shot up this week after U.S. Federal Reserve chairman Ben Bernanke suggested the central bank could start tapering its asset-buying program, under which the central bank now scoops up $85-billion (U.S.) of bonds and securities each month to keep their yields low.
Now interest rates on Canadian bonds are following suit because international investors largely view U.S. and Canadian bonds as alternatives to one another.
This is "uncharted territory," said Toronto-Dominion Bank chief economist Craig Alexander.
"We've never been in a world where the Federal Reserve is buying $85-billion of bonds a month, and now the government is going to start scaling that back."
As investors navigate the choppy waters, the question now, he said, is whether the recent spike in rates will hold. "Do they continue to climb, or does the market take a pause and recognize that it went too far too quickly?"
Whatever the outcome, uncertainty is weighing on everyone from small businesses to pensioners, who wonder how the market will shake out.
The Bank of Canada's key interest rate isn't expected to jump higher than its 1-per-cent level for some time, but government bond yields are at the whim of the market, and these yields are the benchmarks from which so many other products are priced.
Royal Bank of Canada, the country's biggest mortgage lender, has boosted its five-year rates for fixed-rate mortgages twice in the last two weeks to 3.49 per cent, and has also raised rates on mortgages of other lengths. Rival banks are following suit. These hikes follow a period during which rates sank to new lows, luring more people into the housing market. Such low rates prompted Finance Minister Jim Flaherty to lecture banks at a time of high consumer debt and house prices. Now the market is doing his work for him.
Canadians nearing retirement have had few choices for quality, dependable investments over the past few years – something they need at such a vulnerable point in their lives. Rock-solid 10-year federal government bonds that paid north of 4 per cent before the crisis offered returns less than half that amount until early May, and the banks' super safe guaranteed investment certificates (GICs) barely offered more than the paltry inflation rate. That's quickly changing as bond yields rise, widening investment options for baby boomers.
The rates at which businesses of all sizes, from family-run restaurants to major corporations, can borrow money are quickly escalating. These rates are priced off soaring underlying government bond yields, which means the banks and the end borrowers have little control over them. However, the upside is that higher rates make the loans more economical for the banks, because they earn better margins on them. That means the banks should be more willing to lend money out – provided businesses have good reason to borrow.
Low interest rates have caused serious pain for defined-benefit pension plans, and rising rates should be good news for people who are counting on payments from such plans in retirement. Pension accounting rules require plans to calculate a discount rate that determines whether they have enough money to fund their pension liability. This rate is priced off of bond yields, and higher yields translate into higher discount rates, making pension plans more solvent.