If your clients are frustrated because five-year fixed mortgage rates haven’t come down in line with short-term interest rates, they may find some comfort in the fact that this is not out of line with historical experience.

In fact, the spread between mortgage rates and both the Bank of Canada rate and the chartered banks’ prime rate is now around normal levels. It was the lower spread in the period between September 2005 and November 2007 that was unusual.

Various banks’ fixed five-year mortgage rate of 6.65% on May 22 was 340 basis points higher than the Bank of Canada rate, which was 3.25%, and 190 bps above the chartered banks’ 4.75% prime rate.

That is a little lower than the average spreads of 353 bps higher than the Bank of Canada rate and 203 bps higher than the prime rate in the January 2001 to August 2005 period. (It’s worth noting that some banks started lowering mortgage rates by about 34 bps from 6.99% after May 21.)

Clients, however, may be comparing the current spreads with those in the September 2005-November 2007 period, when five-year fixed mortgage rates averaged only 244 bps higher than the Bank of Canada rate and 94 bps higher than the prime rate. What happened in that period was that the banks didn’t match their increases in mortgage rates with the rises that were occurring in short rates. This makes sense because those increases weren’t expected to last a long time. The same thing happened in 1998-2000, which was also a period of rising short rates.

It’s also important to note that the rates on five- and 10-year Canada bonds also didn’t fall with short rates in either of those periods. In fact, there historically has been a closer relationship between mortgage rates and Canada bond rates than between mortgage rates and short-term rates.

But this hasn’t held up in the past few years for 10-year Canadas and has at least temporarily collapsed for both five- and 10-year bonds since December.

There are two factors why this has happened: one is the significant narrowing of the gap between the rates for five- and 10-year Canadas since late 2005; the other is the global credit crisis.

The five- vs 10-year Canada bond spread narrowed to an average of just 11 bps in the September 2005 to November 2007 period vs 67 bps in the January 2001 to August 2005 period — probably as a result of investor confidence that central banks would be able to keep inflation moderate.

It’s worth noting that the spread has widened somewhat since the beginning of this year, to 45 bps, presumably reflecting increased concerns about inflationary pressures from the rising oil and food prices.

But the global credit crunch really increased the spread between mortgage rates and Canada bonds, with banks not lowering their mortgage rates in line with declines in the bond rates. As of May 22, five-year Canadas had a yield of 3.3%, 335 bps lower than the five-year fixed mortgage rate of 6.65%, while 10-year Canadas yielded 3.66%, or 299 bps lower. That compares with spreads of 260 bps and 250 bps, respectively in the September 2005 to November 2007 period.

This probably reflects a lack of enthusiasm on the part of the big banks about making a lot more loans at a time when many of them have had to take charges related to the credit crunch.

Analysts also think the banks are being charged higher rates on loans from other financial institutions than is normally the case.

In addition, banks are believed to have tightened credit standards, so consumers may end up paying higher rates than they would have in normal conditions.

Consumers with good credit ratings usually pay less than the posted rates, but the break currently provided by the banks may be less than it would have been for those same individuals two years ago.

Once the issues surrounding the credit crisis are resolved, the relationship between mortgage rates and Canada bonds — as well as lending standards — should return to normal levels. But it’s not clear how soon that will happen. IE