The Yield Curve
Rates are rising. We know that to be a fact. And further rate increases by summer’s end, are certainly not out of the question. However longer term rates have been slow to move. The result? A flat yield curve. What are the implications for you?
Investors who commit to tying up their money for longer periods of time take on an added element of risk over short term investors. The risk element is the risk of the unknown. Quite simply, it’s harder to predict economic conditions –inflation, monetary policy, the global economy, over a decade, than over a number of months. The term “premium” is the compensation lenders demand for making longer term loans. This results in a positive slope to the yield curve (i.e. it slopes upwards) as term extends.
But wait a minute. If shorter term rates have been increasing, should we not be seeing a similar increase to longer term rates? Typically, yes.
However, the yield curve is relatively flat. Why is this so? Typically longer term rate movements are tied to three components. The expectation of shorter term rates, expected inflation, and term premiums demanded by longer term bond holders. Inflation is, and appears to remain low. As we know from Economics 101, inflation erodes the value of a promise to pay a future fixed sum. Investors now feel however that inflationary pressures are manageable, and there seems to be a general sentiment that we are not in for a period of runaway inflation. In other words, longer term rates have not risen as much as one one perhaps have expected, in the face of shorter term increases. The difference between the yield of 5 and 10 year Government of Canada Bond rates were a modest 14 basis points last week. Compare that with January 2018, when the difference was 19 basis points. Compare that with January 2015 and January 2010, when the spread was 65 basis points, and 89 basis points respectively.
Perhaps an Opportunity?
If longer term rates are relatively low, as evidenced by a flat yield curve, what are the implications for mortgage borrowers? Perhaps this presents an opportunity to lock in rate. In our post entitled Is It Really All About Rate, I discussed the often overlooked focus on term, as a strategy for borrowers. While most commercial mortgage borrowers select a 5 year term, a longer term strategy may be appropriate for buy and hold investors, particularly as the flat yield curve provides an opportunity to lock in relatively inexpensive longer term funds.