Euro-zone Crisis Update … And Why it Matters to Canadians

Now that the U.S. election is over, markets will shift their attention back to the European Union (EU), and more specifically, the 17 of its 27 member states that share the euro as their common currency, known as the euro zone.

But first, some readers might be wondering why I have devoted so much ink to the euro-zone crises over the last year, especially considering that the entire EU buys less than 5% of Canada’s exports. Here are three reasons:

• Investment markets are dominated by either fear or greed and over the last several years, fear has ruled the average investor’s mindset. Government of Canada (GoC) bonds are on a very short (and continuously shrinking) list of safe-haven assets, and this special status has fueled unprecedented demand that has driven these yields down to today’s ultra-low levels. The euro-zone crisis has been the primary contributor to the ‘fear premium’ that is currently priced into GoC bond yields, and since our interest rates are priced in relation to these yields, Canadian mortgage rates have a very direct link to ongoing euro-zone developments.
• The EU is the largest single market in the world, accounting for 20% of global GDP.  Not surprisingly, the EU is the largest buyer of U.S. exports and well-known Canadian economist David Rosenberg recently estimated that there is an 86% correlation between the performance of the U.S. and EU economies. While we are not directly dependent on EU export demand, we have a strong indirect link because we both have deep connections to the U.S. economy.
• The EU is also China’s largest customer, buying about 20% of its total exports. An extended economic slump in the EU will continue to slow China’s economic momentum and in turn, reduce Chinese demand for commodities. China is the world’s largest marginal buyer of commodities, which means that commodity prices move in response to changes in Chinese demand. As such, our largely resource- and commodity-based economy has a second strong indirect link to events unfolding inside the EU.

Now that Floridians have finally finished counting their ballots and before talk of the coming U.S. fiscal cliff pushes its way back up our worry list, let’s check back in on the euro zone, which has been quietly fraying at the edges of late.

The European Central Bank (ECB) met last Thursday and at the post-meeting press conference, ECB President Mario Draghi offered some less than encouraging comments. He offered a rather gloomy economic forecast, saying that he does not see much improvement between now and the end of the year, while adding that “looking ahead to next year, the growth momentum is expected to remain weak” (despite this, the ECB left its main interest rate unchanged and offered no hint that it was even considering future rate cuts).

The shocker for me was when Mr. Draghi said that the ECB was “more or less done” helping Greece. While his comment was made as part of an argument that euro-zone governments and their national central banks should take over administering the Greek bailout and that the ECB’s hands were effectively now tied, those words were a far cry from his earlier promise that the ECB will “do whatever it takes” to save the euro.  (On the Greek bailout file, I also note that Greece must repay five billion euros of maturing treasury bills next week at the same time that euro-zone leaders want to delay the country’s next bailout payment until further proof of Greek compliance with its bailout terms is provided and deemed satisfactory. The Greek tragedy continues …)

Mr. Draghi was candid in offering this overall assessment of the euro zone: “We are observing a fragmentation of the euro area, re-nationalization of the banking systems, [and] a difference in costs of funding that go beyond the fundamentals.”

Speaking of the differences in costs of funding … the ECB and Spain are now engaged in a game of high-stakes chicken. When the ECB recently created its Outright Monetary Transaction (OMT) bailout fund, it was specifically designed with Spain’s inevitable bailout in mind. But Spanish Prime Minister Rajoy isn’t willing to formally request a bailout and submit to another round of austerity measures until the ECB makes it clear at what bond yield level it will intervene to support Spanish sovereign bonds.

In essence, Mr. Rajoy wants assurances that the ECB will keep Spain’s cost of funding at manageable levels before he goes back to the electorate with more budget cuts and tax increases. (Think of this as his wanting to do a political cost/benefit analysis.) Despite being backed into a tight corner, he is using the same approach that Greece tried to impose on its bailout negotiations, hoping that fear of a Spanish default will give him some kind of mutually-assured-destruction leverage.  Mr. Draghi, for his part, seems to believe that stalling for time will work in his favour (which it will, until bond-market investors will no longer indulge him … and then it won’t.)

Despite the chaos around it, in the first years of the euro-zone crisis Germany has fared remarkably well and that has given German Chancellor Angela Merkel the political cover she needs to support various euro-zone bailout measures. But on Wednesday of last week, Mr. Draghi acknowledged that while “Germany has so far been largely insulated from some of the difficulties elsewhere in the euro area…the latest data suggest that these developments are now starting to affect the German economy.”  This comment was backed up by data showing a steep decline in German GDP growth (4.2% in 2010, 3.0% in 2011, 0.5% in Q12012 and 0.3% in Q2 2012 and forecast to be lower still in Q3 2012).

Germany has been a reluctant participant in euro-zone bailouts to date and the incremental cost of its continued support will only increase. Today, the crisis is acting as a powerful drag on the country’s economic growth, but eventually, as we see more bailouts with German backing as their centerpiece, Germany’s prized credit rating will inevitably suffer and its cost of funding will increase. This will make it increasingly difficult for Chancellor Merkel to reconcile German interests with what is best for the euro zone, reminding me of Luxemburg Prime Minister Jean-Claude Junker’s prescient quote: “We all know what to do, we just don’t know how to get re-elected after we’ve done it.”

Five-year GOC bond yields were down two basis points for the week, closing at 1.30% on Friday. Five-year fixed-mortgage rates were largely unchanged and are still available at around 3%.

Variable-rate mortgages have been gaining a little in popularity as short-term fixed rates have increased. Borrowers can still find a five-year variable rate with a discount of prime minus 0.40% (which works out to  2.60% using today’s prime rate) and that offers a small savings over one-year fixed rates which are now priced a little higher in the 2.64% to 2.80% range (depending on the terms and conditions offered). While I still think paying a small premium for the stability of a fixed rate makes sense for risk-averse borrowers, the case for a variable rate is bolstered by increasing evidence that rates could stay low for much longer than most experts have been forecasting. But for the rate-driven borrower who can handle the risk of higher payments, the variable rate may not have to concede its long-earned reputation for offering the cheapest cost of borrowing over the long run just yet.

The bottom line: For the reasons list above, I believe that ultra-low mortgage rates will continue to offer Canadians a silver lining for the clouds that will otherwise darken our cloudy economic days ahead.