From Canadian Business Online, June 9, 2004
How mortgage rates are set
There seems to be a lot of confusion about how mortgage rates are set in Canada.
By Andy MacDonald

There seems to be a lot of confusion about how mortgage rates are set in Canada. Every time the Bank of Canada announces a change to its target for the overnight rate (formerly the bank rate), my phone rings off the hook with people inquiring about the latest changes to mortgage rates. When I explain to them that there is no correlation between changes in the overnight rate and changes in mortgage rates, I get the same sort of reaction that Columbus must have got when he announced that the world is round, not flat.
Fixed residential mortgage rates are determined by changes in the bond market and the competitiveness of the chartered banks in Canada. The Bank of Canada has very little, if any, influence on them.
A great example of this was the rate change by the Bank of Canada on April 13, 2004. The Bank announced it was lowering the overnight rate by one quarter of 1%. The average consumer thought that this would mean that mortgage rates were going down when in fact mortgage rates were rising. (The 5-year fixed rate jumped by more than one half of 1% around this same time and it continued to rise in May.) If you compare changes to the overnight rate with mortgage rate trends, you will notice that sometimes mortgage rates went up, sometimes they went down and sometimes they stayed the same, regardless of which way the overnight rate was adjusted.
The chartered banks set their mortgage rates based on yields in the bond market. A Government of Canada bond represents a risk free investment to the banks. If the banks choose to invest in a mortgage, they are taking on added risk and incurring costs to set up and service it. The banks will set their mortgage rates high enough above the equivalent bond yield to cover their costs and provide some sort of profit margin for the added risk they are taking on. Over the past decade the spread above the equivalent bond yield has narrowed as the competition for mortgage business has intensified between the big banks.
As an example, a 5-year Government of Canada bond is yielding about 4.00% today and most 5-year discounted mortgage rates are set at about 5.20%. This means that the chartered banks are only earning a risk premium of 1.20% before expenses.
So now you might be asking, how are bond yields determined? By investors' expectations for interest rates in the future. These expectations are arrived at by assessing the state of the Canadian economy and predicting where it is headed relative to other world economies. There is no science to such predictions (although some economists spend a lot of time trying to make it into a science). At best the markets make their best guess and keep updating their guess every day.
My suggestion to anyone who wants to predict when mortgage rates will rise and fall is to track Government of Canada bond yields daily. Most financial papers list the bond yields for various terms each day. It is normal for yields to change slightly from day to day, but if you start to see consistent increases or decreases then you can expect that the banks will be adjusting their mortgage rates accordingly. If you are interested in a 5-year mortgage rate then track the equivalent 5-year Government of Canada bond; if you are interested in a 1-year mortgage rate then track the equivalent 1-year Government of Canada bond, and so on.
Now that I have told you that the Bank of Canada does not have an impact on mortgage rates, there is one exception to this rule. Most variable rate mortgages are affected by changes to the prime rate as set by each of the chartered banks. The prime rate will change, in the same direction and by the same amount, as any change to the overnight rate. So if the Bank of Canada announces a decrease in the overnight rate by one quarter of 1% (or "25 basis points" in financial parlance), then you can expect most variable rate mortgages to also drop by one quarter of 1%.
So unless you have a variable rate mortgage, don't pay attention to the hype surrounding interest rate announcements by the Bank of Canada. If you want to know where fixed rate mortgage rates are headed, follow changes in the bond market.
Andy MacDonald (BA Econ.) is president of MortgageBroker Inc. He has more than two decades of financial services experience and has long been an advocate for consumers within the mortgage industry. Visit his Web site at MortgagesInCanada.com.