The Distant Risk of Higher Mortgage Rates

Today’s economic data imply that our mortgage rates will stay low for the foreseeable future. So much so that even the ‘end-of-low-rates-is-nigh’ forecasters at the Bank of Canada (BoC) have finally come around to the lower-for-longer rate view.

Cue my contrarian itch, which reminds me of Bob Ferrell’s rule number nine from his famous Ten Market Rules to Remember: “When all the experts and forecasters agree – something else is going to happen.”

Mr. Ferrell’s rule reminds me that markets have a long history of surprising us and while the odds of rates staying low for some time yet are stacked in our favour, make no mistake, the seeds that will eventually push rates higher (perhaps dramatically so) are being sown in abundance.Bluntly put, there is no historical precedent for what central banks are doing today. Not even close. We are knee-deep into a period where these banks have become the financial markets’ marginal buyers of sovereign debt, artificially suppressing government bond yields and grotesquely distorting free-market forces.

This money-printing-by-another-name is politically expedient because it allows over-indebted governments to continue running huge deficits and expanding crippling debt levels that have, in many cases, been some seventy years in the making. Consider the following:

• The U.S. Federal Reserve will buy about 90% of all newly issued U.S. treasuries and mortgage bonds in 2013. (The U.S. Fed’s balance sheet was $800 billion in 2007, is about $2.8 trillion today and is expected to grow to $6 trillion by the end of 2015.) What happens when U.S. unemployment finally reaches the Fed’s 6.5% target rate and the Fed wants to unwind its quantitative easing programs? Do you think bond-market investors will be happy to fill that huge void in demand by buying bonds priced at negative real-return yields?
• The Bank of Japan (BoJ) has recently embarked on a new round of aggressive money printing that it plans to continue until the Japanese economy reaches a target inflation rate of 2%. But Japan’s bond yields are priced at microscopic levels after two decades of deflation. While any positive yield is attractive in a deflationary environment, if the BoJ is successful in creating 2% inflation, today’s Japanese bond yields will have to adjust higher or they will produce negative real returns. It already costs Japan 50% of its total government revenue to service its national debt, and each one percentage point rise in Japan’s cost of capital will cost the country another 25% of its total revenue. Put another way, if Japanese government bond yields go up by 2%, Japan’s entire tax revenue base will be needed just to pay its annual debt-servicing costs.
• The European Central Bank (ECB) has long since become the marginal buyer of sovereign debt issued by the euro zone’s distressed peripheral countries. The ECB has mostly done this by recapitalizing banks so they could continue buying their governments’ bonds, but now the plan is to just buy sovereign debt outright in the secondary market under the Outright Monetary Transactions (OMT) program. Whether the ECB has the will, or even the required backing, to do what will ultimately be required to bail out Spain et al. is still an open question that will continue to be tested by bond-market investors. It is only the perceived strength of the ECB’s balance sheet that is holding down bond yields in the euro zone’s imperiled peripheral countries.

By comparison, the BoC has not engaged in any quantitative easing since the start of the Great Recession and our federal government enjoys one of the world’s few remaining clean AAA ratings. But we are a small and open economy that will not be immune from bond-market panic if a sovereign government defaults on its debt.

If bond-market investors start to doubt the sanctity of government guarantees, they may well demand higher yields for all sovereign debt. Then it will be small consolation to say that our rates are among the lowest in the world if they are significantly higher nonetheless. On the other hand, if the U.S. Federal Reserve’s unprecedented monetary expansion eventually leads to higher inflation, our deeply integrated and heavily U.S. dependent economy will inevitably import that inflation.

As of today, these interest-rate threats are still distant. The risk of sovereign default appears contained for the time being and the threat of U.S. inflation does not seem imminent. For now. But every new dollar, yen or euro that is printed or pledged is like another grain of sand being added to a pile that history says will eventually collapse under its own weight. Most of the experts I read think this will happen one way or another. Their only real debate now is about the timing of the end result.

Government of Canada (GoC) bond yields were four basis points lower for the week, closing at 1.48% on Friday. Five-year fixed-mortgage rates can still be found in the sub-3% range and ten-year fixed rates are now offered at rates as low as 3.69% (If rates do turn sharply upward, the ten-year fixed could make those who took it look like geniuses – of the low cost-of-borrowing variety .)

Five-year variable-rate mortgages are available in the prime minus 0.40% range for well-qualified borrowers and variable-rate price competition among lenders is increasing.

The bottom line: When conservative Canadian borrowers evaluate the range of possible interest-rate outcomes that await us on the distant horizon, they are understandably concerned. They worry that at some point trying to save money with variable-rate or short-term fixed-rate financing may be akin to picking up a dime in front of a bulldozer.

My gut says that it will be higher inflation, not sovereign default that will eventually push rates higher – but I still think the bulldozer is far enough away to grab a few more dimes in the meantime.