Fixed and Variable Rates are Closest Since 2016

The gap between the best 5-year fixed rates and best variable rates is the smallest its been in two and a half years.

We’re talking less than 1/8th of a percentage point between them.

Depending on the equity a borrower has, folks can even find 5-year fixed rates that are below the best variable rates.

What’s Provoking It

One reason for this oddity is shrinking “term premiums.”

What’s a “term premium?”

It’s essentially the extra compensation (yield) that investors demand for holding bonds longer. And it’s been dropping.

“…The term premium has been falling steadily since 2009 and is currently at or below zero,” said investment firm Neuberger Berman in this recent report.

Reasons for the declining term premium include:

• less concern from investors about inflation volatility
• central bank bond buying (greater demand for bonds results in lower rates, other things equal)
• rate hikes from central banks (when the Fed raises its policy rate, for example, the term premium usually decreases—as reflected in the narrowing spread between 10-year and 1-year treasury bonds)

Coupled with diminished expectations for economic growth, the shrinking term premium has helped invert Canada’s yield curve—i.e., made the 10-year bond yield trade below the Bank of Canada’s overnight rate.

This is largely why 5-year fixed and variable rates are so tight right now.

Esoterica: An inverted yield curve doesn’t technically require a negative term premium. The yield curve can invert primarily because investors expect lower rates in the future. In other words, if the Bank of Canada is hiking but market thinks short-term rates will be lower over the next 10 years, the 10-year bond yield can drop below the overnight rate (as it has at the time this is being written).

Will the Term Premium Rebound Higher?

Eventually, it will.

Neuberger is just the latest Wall Street firm to project a rising term premium. It believes it’s going back to its long-term average thanks to pro-growth U.S. economic policies (which could create inflation risk), falling demand for U.S. bonds and greater bond issuance, among other things. (Remember, most of our rate movement in Canada is influenced by U.S. rate moves.)

Mind you, Neuberger’s isn’t exactly a bold prediction. Financial markets always revert to their mean…someday.

It’s true that the factors Neuberger cites could swell the term premium. And if the term premium grows, the spread (difference) between 5-year fixed and variable rates will likely grow as well.

But that could potentially take a long…long time—anywhere from multiple quarters to several years.

How Borrowers are Playing It

One might think that 5-year fixed rates are overwhelmingly more popular, since:

A) fixed rates seem relatively cheap compared to variables, and

B) variables are perceived as higher risk.

But, anecdotally speaking, floating rates under 3% are still drawing considerable interest, say brokers and lenders. While we won’t have hard stats on this for weeks, it appears uptake on variables remains strong—despite them selling for almost the same prices as long-term fixed rates.

Many borrowers simply don’t believe that rates will surge in the next five years. All the recent press about yield curve inversion foretelling a recession is fuelling that thinking even more.

Indeed numerous factors could keep term premiums—and rates in general—down. Not the least of which are low inflation expectations, self-fulfilling negative sentiment (e.g., from people who believe the yield curve’s warning signs) and the threat that governments buy more bonds, which keeps rates lower. By the way, the U.S. Fed may have to buy even more bonds than it did before the global financial crisis.

The takeaway here is that there’s a reason why the gap between fixed and variable rates is compressed. And the reason is not that investors expect a booming economy, up-trending inflation and surging interest rates.