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How the Fed's "Tapering" Will Affect Fixed Rate Mortgages

Yesterday, the U.S. Federal Reserve announced that, starting in January, it would reduce its $85 billion a month bond purchase program by $10 billion to $75 billion.  This came as a surprise to most market watchers who had not expected the Fed to begin "tapering" until closer to the end of Ben Bernanke's tenure as Fed Chairman next year.

The effect of the Fed's reduction in stimulus will sooner or later make itself felt in fixed rate mortgages, even here in Canada.  Fixed rates, unlike variable rates, are governed primarily by bond yields.  When determining the rate for a fixed rate mortgage, a lender will look to the yield on the corresponding government bond.  Although lenders may also fund fixed rates from a variety of other sources, bond yields are looked to as the benchmark for determining a lender's cost of funds for fixed rate mortgages. 

The Fed's bond purchase program kept bond yields low by creating an artificial demand for debt.  As with the sale of most goods and services, greater demand will drive prices up.  For example, with high demand a $100 bond paying 3% might be sold for $101, thereby reducing the effective yield from 3% to about 2%.  With a lower demand, bond prices will begin to sink and yields will rise.  

This reduction in stimulus is only just beginning and there are many other factors that will come into play over the next year.  But if the Fed continues tapering we are bound to see a steady rise in bond yields.  Already the 5 year Canadian Bond has hit a day high of 1.90% compared to a day low of 1.80% yesterday.  This may settle back a bit as the news is absorbed by the market and put in context with other factors but the ongoing trend is likely to be upward.  If so, mortgage lenders will be under pressure to adjust their fixed rates as well. 

For further information about the Federal Reserve's announcement and its effects, please see the following links:

The Globe and Mail - Fed surprises Wall Street, plans to taper massive U.S. stimulus program

Financial Post - Markets applaud announcement of Fed tapering

The Telegraph - Federal Reserve begins tapering QE: what the analysts say


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John Freeland Smith


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