Bond yields have been trending upward precipitously since early May over growing concerns with inflation. As inflation expectations rise, investors react by adjusting their bond holdings, which can have an effect on various sectors, including mortgage rates. 

It’s possible that the bond market’s negative reaction to inflation concerns could be overblown, which would be good news for mortgage rates. 

But what is the likelihood that we’ll see fixed rates start to drop?

 

Understanding Inflation Concerns

Inflation refers to the general increase in prices of goods and services over time. It erodes the purchasing power of money and affects various aspects of the economy. In recent months, concerns about rising inflation have surfaced due to factors such as increased government spending, supply chain disruptions, and pent-up consumer demand as economies recover from the COVID-19 pandemic.

You don’t need me to tell you that the cost of everything continues to rise. It’s not just mortgage rates. If the Bank of Canada had kept rates low, then our cost of living would get completely out of control.

 

Canadian Bond Market and Inflation Expectations

The bond market plays a crucial role in reflecting market sentiment and expectations. When investors anticipate higher inflation, they demand higher yields on fixed-income investments like bonds to compensate for the eroding purchasing power of future cash flows. As a result, bond prices decline, pushing yields higher.

As fixed mortgage rates are largely influenced by bond yields, an upward trend in yields will place upward pressure on rates. When bond yields rise, lender profit margin decreases which leads to fixed mortgage rate increases.

 

Is the Bond Market Overreacting?

While inflation concerns are valid, it’s important to evaluate whether the bond market is overreacting. This is not all that uncommon. Overreactions in the market can lead to volatile price movements that may not be entirely justified by underlying economic fundamentals. 

If the bond market’s reaction to inflation is overblown, it is possible that mortgage rates could experience short term volatility rather than a sustained upward trend. In other words, mortgage rates would start to drop.

While inflation increased in May for the first time since July 2022, it’s expected to drop when the next inflation report is released on June 27th. But if inflation were to come in higher than expected, then it’s almost certain that the upward trend will continue.

If it comes in lower than what the analysts are expecting, then we could see bond yields start to fall.

 

Market Expectations vs. Economists’ Predictions

The bond market is currently expecting two more 0.25% increases from the Bank of Canada before the end of the year. However, most economists are only forecasting one more increase in the third quarter, without any further movement for the rest of the year. This discrepancy in views could be an indication that the bond market is overreacting.

If the inflation report on June 27th comes in more favourable than expected, the bond market may start to sing a different tune by reacting with reversal in trend. If it turns out that the bond market was in fact overreacting, then it’s possible that the expected downward trend in yields to follow could be steep. This would result in heavy downward pressure on fixed mortgage rates.

 

Conclusion

While the bond market is sensitive to inflation concerns, it is crucial to assess whether the reactions are proportional to actual economic fundamentals. Overreactions in the bond market can lead to short-term volatility in mortgage rates, but the long-term impact may not necessarily be as severe as initial market movements indicate.

Whether the bond market is overreacting or not is still unknown. The inflation report expected on June 27th will play a key role in what we can expect from mortgage rates moving forward. Whatever happens, the market will adjust accordingly.

Time will tell and anything can happen.