Module 5 · The Yield Curve and the Bank of Canada Core

News about “interest rates” usually means one number. In fact there is a different rate for every length of loan, from overnight to thirty years, and they do not always move together. This module shows you the whole curve, who moves which end of it, and what that means for your bonds, your GICs and your mortgage.

What the yield curve is

Take bonds from one borrower, usually the national government, and line them up by how long they have until maturity: three months, two years, five years, ten years, thirty years. Plot each one’s yield. The line that joins the dots is the yield curve.

Using one borrower matters. It removes credit risk from Module 4, so the only difference between the points is time. The Government of Canada curve is the benchmark in Canada, and the US Treasury curve in the US.

The curve comes in three basic shapes:

• Normal (upward sloping): longer bonds yield more than shorter ones. This is the usual shape, because lenders want extra for tying money up longer and taking on more duration.
• Flat: short and long bonds yield about the same.
• Inverted (downward sloping): short bonds yield more than long ones.

The slope of the curve is usually measured as the ten-year yield minus the two-year yield.

Example. The two-year Government of Canada yield is 3.2% and the ten-year is 3.9%. The slope is 3.9% − 3.2% = +0.7 points, or +70 basis points: a normal, fairly gentle curve. If the two-year were 4.0% and the ten-year 3.3%, the slope would be −70 basis points: inverted.

What the Bank of Canada controls

The Bank of Canada sets one interest rate directly: the target for the overnight rate, the rate at which big banks lend to each other for one day. It announces decisions on eight scheduled dates a year. In the US, the Federal Reserve does the same with the federal funds rate.

That one rate pins down the very start of the curve, and the short end follows it closely:

• Banks’ prime rate, which usually sits a fixed gap above the overnight rate (about 2.2 points in recent years), and with it variable-rate mortgages and lines of credit.
• Savings accounts and short-term GICs.
• Treasury bills and short-term government bonds.

The long end is different. Nobody sets the ten-year or thirty-year yield. It is set by millions of buyers and sellers in the bond market, based on:

• where they expect the overnight rate to be over the coming years,
• what they expect inflation to be (Module 6),
• how strong they expect the economy to be,
• and global yields, especially in the US, because money moves easily across the border.

Inversion

Why would anyone lend for ten years at a lower rate than for two? Because they expect rates to fall. If investors believe the central bank will have to cut rates sharply, usually because the economy is heading for a slowdown, they lock in today’s long-term yields, pushing them below short-term yields.

That is why an inverted curve gets so much attention. In the US, an inverted curve has come before most recessions of the past fifty years. But it is a poor timer:

• The gap between inversion and recession has ranged from months to a couple of years.
• There have been false alarms. In 2022, both the Canadian and US curves inverted and stayed inverted for roughly two years, one of the longest inversions on record, and the US did not fall into recession during that time.

Bonds and your mortgage

The yield curve reaches into almost every Canadian household through mortgages, and the two main kinds follow two different parts of the curve.

Lenders fund five-year fixed mortgages at rates linked to five-year bond yields, then add a spread to cover their costs, risk and profit. Example. If the five-year Government of Canada yield is 3.0% and lenders add about 1.5 points, five-year fixed mortgages land near 4.5%. If the five-year yield rises half a point, fixed mortgage rates tend to follow within days or weeks, even if the Bank of Canada has not changed anything.

That is why fixed mortgage rates sometimes rise in the same month the Bank of Canada cuts. The article How bond yields set Canadian mortgage rates goes into more detail, and the Master Your Money course covers choosing a mortgage in Canadian mortgages explained.

Using the curve

The curve does not tell you where rates are going. It does tell you how much you are being paid to take on more duration, and that helps you choose between short and long bonds or GICs.

When the curve is flat, going longer pays very little. Example. A two-year GIC pays 3.5% and a ten-year government bond yields 3.7%. The ten-year bond pays just 0.2 points more, but with a duration of about 8.5, a half-point rise in yields would cut its price by about 8.5 × 0.5 = 4.25%, more than twenty years of that extra 0.2 points. Short terms give almost the same yield with far less risk.

When the curve is steep, longer bonds pay noticeably more, which can make extending worth it for money you won’t need for many years. You are still taking duration risk, but you are being paid for it.

When the curve is inverted, short-term GICs and savings can pay more than long bonds. That is tempting, but remember why: the market expects rates to fall. When your short GIC matures, you may have to reinvest at a lower rate. Long bonds lock in today’s yield, and they rise in price if rates do fall.

Put it into practice