Yields, Swap Rates & Fixed Rates — Higher Yet Again
Bond yields have been going vertical.
By early Thursday, the 5-year yield—which influences long-term fixed rates—was up as much as 20+ basis points in less than 48 hours. That's an unusual move and it was driven by optimistic economic comments from the U.S. central bank.
A “swap” (interest rate swap) is an agreement to exchange two different types of interest payments: fixed-rate payments and floating-rate payments. Financial institutions buy swaps to hedge interest rate risk and lock in profits.
A simplified example of hedging: A bank with 5-year fixed mortgages receives fixed-rate payments from borrowers. That same bank also has short-term deposits. If short-term rates rise, the bank would have to pay higher rates to depositors, but be left with the same fixed rate payments from its mortgages. To solve that problem, the bank buys a swap that lets it receive floating-rate payments (at a higher rate than it has to pay out to depositors). In exchange, the bank must give its fixed-rate payments to the swap seller.
Why swaps matter
The difference between the 5-year swap rate and the 5-year government yield is called the "swap spread."
When the swap spread gets wider, fixed mortgages can become more expensive to hedge, other things being equal. That often happens when bonds sell off and yields soar. Lenders then pass along that added cost to borrowers.
Here’s a chart of the swap spread from earlier Thursday. As you can see, it has been making new relative highs.
(Click to enlarge)
Swap spreads may continue to widen if Canadians rush to lock in low rates. In that scenario, banks would have even more fixed-rate mortgages to hedge in the swap market.
It’s hard to say how long rising yields and widening swap spreads will exert upward pressure on rates. So if you need a mortgage in the next 180 days, call your broker or banker soon for rate hold. Some protection is better than none, and you can always cancel a rate hold if needed.
Rob McLister, CMT