Euro-Zone Crisis Keeping Canadian Bond Yields and Mortgage Rates Low

The euro-zone crisis returned to its roots last Friday when Greek riots erupted in response to demands for still more austerity measures from the “Troika”: the European Commission, International Monetary Fund and the European Central Bank (but really Germany).

While the markets have been more focused on Italy and Spain lately (where bond-yield pressures have begun to ease), Greece remains the euro zone’s bailout test case. Any deals struck with the Greeks will set a precedent for future bailouts; and with Portugal waiting in the wings, there is already a line forming. 

Let’s recap how Greece and the wider euro zone have reached this point:

At its most basic level, Greece’s economy is simply not competitive. Its government spends more than its citizens pay in taxes, and foreign investors are no longer willing to fund the country’s perpetual shortfall unless wholesale changes are made to how it operates.

If Greece wants more money, and it needs 14.5 billion euros by March 20^th to repay a bond that it has coming due, its citizens are forced to accept austerity measures that probably feel like open-heart surgery, a liver transplant and a lobotomy all rolled into one. To wit, the Troika is demanding that Greece slash its minimum wage by 22%, gut its government entitlement programs (including sacred pension plans), and fire its public sector employees by the tens of thousands in wave after wave of layoffs that will stretch out over many years.

To the average Greek, this must make an already dire situation look hopeless. The national unemployment rate is at 20% (youth unemployment is much higher), the country is already in its fifth year of recession, and all of this is being orchestrated by an unelected prime minister at the behest of foreign leaders. Greece’s ultimate road to salvation will only come when the economy achieves sustainable growth, and it’s hard for any observer inside or outside the country to see how they achieve that anytime soon.

It also isn’t lost on the Greeks that almost all of the loans they would be defaulting on were made by foreign banks, and that the largest holders of this outstanding debt reside in Italy and Spain. These already vulnerable countries can ill afford to bail out their banks in the event of a full-scale Greek default, and since German and French banks are the largest holders of Spanish and Italian bonds, it is easy to see the potential for widespread contagion. The Greeks know that their foreign taskmasters have skin riding on their fate.

Greece’s current government is convinced that all of the alternatives to additional austerity measures are untenable and last night it pushed through the latest required reforms, but democracies often have elections at inconvenient times, and Greece may hold one as early as this spring. That could trigger a new round of brinkmanship between a more populist Greek government and euro-zone leaders who believe that their own political survival depends on convincing their respective voters that today’s bailouts are only being provided in exchange for deep structural changes in the countries that needed them.

Five-year Government of Canada (GoC) bond yields were trending higher early in the week as investors grew more optimistic about the strength of the U.S. recovery. Then Greek riots brought the euro-zone crisis back to centre stage on Friday and yields beat a hasty retreat. We finished 5 basis points higher for the week and closed at 1.41% on Friday.

Several Big Five banks withdrew their three and four-year fixed rate specials late last week, citing higher funding costs due to “global economic concerns”. This convenient justification is not supported by the data, and perhaps in recognition of this, several other lenders have decided to keep their fixed-rate specials in place for at least a little longer.

Variable-rate mortgages are still only available with small discounts off of prime rates, and are less than .5% below fixed-rate mortgages that are offered for the same term. For my money, that just doesn’t give you enough of a margin of safety to work with and it makes fixed rates look more attractive by comparison.

The bottom line: Each time the euro-zone crisis flares up, investors prioritize the preservation of their capital over a return on their capital, and this drives up demand for ultra-low-risk investments like GoC bonds. ‘Heightened market-risk with no subsequent follow through’ is the sweet spot for GoC bond yields, and by association, our mortgage rates. Recent euro-zone events lead me to believe that Canadian mortgage borrowers will continue to benefit from this sweet spot for the foreseeable future.