As the gap between long and short term mortgages rates continues to narrow - at the time of writing the 1-year posted rate for most institutions was within 1% of the 5-year rate - the dilemma mounts for the average borrower not already locked into a long-term deal.

To attempt to address this dilemma, I'll give some important background first.

The Canadian money markets have observed a rare phenomenon over the past few months - rising short-term mortgage rates combined with stable or falling long-term rates. This phenomenon is referred to as a "flattening yield curve". Technically, the "yield curve" simply refers to the line traced by yields (vertical axis) on Government of Canada securities - Treasury Bills and Bonds - of differing maturities (horizontal axis). Generally, the longer the maturity, the higher the yield to the investor for providing "patient money".

Historically, the gap between 3 month T-Bill yields and 30-year Bond yields has averaged about 3.5- 4.5%. At time of writing it was down to 2.29%.

What has caused that gap to halve - and created the dilemma for mortgage borrowers - is the relationship between Bank of Canada market activities and the value of longer-term Canadian securities in world capital market.

Two of the main reasons foreigners would bid up the value of Canadian securities are:

1. the likelihood that the Central Bank will protect and maintain the value of the currency. This will ensure that foreigners' Canadian-dollar investments will remain steady or increase in relation to their own; and
2. the ability of the Federal Government to consistently improve or maintain high economic performance, enhancing the investment value of the bond.

On the one hand, defending the dollar in uncertain times has entailed ratcheting up the Bank of Canada Prime by 3/4%, causing parallel increases in T-Bill yields, Chartered Bank primes and short-term mortgage rates. But this action, combined with strong economic performance and a decreasing supply of new long-term bond issues, has actually increased the relative demand for the longer-term issues, driving their price up and yields down.

The Bond Market is the great leveler (see related story in themortgage.com)

Low and stable bond yields have allowed Financial Institutions to keep 5 to 10 year mortgage rates at 40-year lows, and even to continue to discount them.

So, returning to the main purpose of this analysis with some knowledge of the dynamics, how can we use them to decide the best course of action with our mortgages?

The challenge is to estimate whether future short term rates will consistently exceed current long-term rates.

If you feel they will, then the optimal decision would be to lock in at your best rate now.

If you feel they'll stay below current long-term rates as the Canadian dollar strengthens or stabilizes, then the best action is to stay with a short-term or variable rate mortgage.

Following is a brief list of major contributing factors to higher rates, both long and short. Use it as a checklist to gauge your own and your clients' risk profiles for decision making purposes. If you (or they) feel strongly that one or more of the listed events will occur, a reasonably logical decision can be made as to the best course of action.

HIGHER SHORT-TERM RATES WILL RESULT FROM:

• domestic political instability; eg. resurgent popularity of the PQ agenda (separendum/neverendum)
• rampant inflation from an overheated economy
• relative strengthening of the US dollar (short-term International crisis, a new Gulf War, etc.)
• continued economic disaster in potentially strong markets for Canadian goods (Asia, Japan)

HIGHER LONG-TERM RATES WILL RESULT FROM:

• worsening Canadian economic performance, especially continued high unemployment;
• rampant inflation - a double-whammy for long AND short rates;
• major flow of capital into other major countries upon their improved fortunes (e.g. long-term out-performance of Canada by Germany, Japan or the EU);
• political upheaval on the international scene that potentially impacts the world economy (capital will flow to larger, stronger countries).

So if you're in a short-term mortgage now or that inflation will return to 70's and 80's levels, or both, the best decision for you today would be to lock in your best 5-year deal now. If you see the economic and political future of Canada and the rest of the world as rosy, you should probably stay short and gather in those smaller gains while continuing to watch for signs of trouble in the markets.

jurock.com

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About the Writer
Tony Humble is Chief Operating Officer of Online Mortgage Explorer, and a frequent contributor to the Financial Post and Jurock.com's Real Estate Insider.

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