The Bank of Canada Becomes More Cautious on When Mortgage Rates Will Rise

Bond-market yields yo-yoed last week, with more subdued comments from the Bank of Canada (BoC) pushing them down last Wednesday before strong employment reports from both the U.S. and Canada pushed them higher on Friday.

When the BoC met last week, it kept its overnight rate unchanged at 1.00% as expected. In its accompanying commentary the Bank softened its interest-rate guidance once again, saying that “the considerable monetary stimulus currently in place will likely remain appropriate for some period of time, after which some modest withdrawal will likely be required”.

Here are my key takeaways from the Bank’s latest statement:

• The BoC offered a more optimistic view of global economic growth, thanks largely to improving conditions in China, and it attributed the fourth-quarter slowdown in our domestic economic momentum to a decline in inventories. This is noteworthy because a slowdown that is caused by a reduction in inventories can be transitory if businesses subsequently increase their production and replenish their stockpiles quickly.
• The BoC statement referred to “a more constructive evolution of imbalances in the housing sector”. This means that the Bank is now less concerned about the risk of housing and credit bubbles. That is significant because BoC Governor Mark Carney has repeatedly referred to rising household debt levels as the greatest threat to our domestic economy.
• The BoC said that “inflation has been somewhat more subdued than projected in the January MPR”, acknowledging that it once again overestimated our rate of inflation in its forecasts. The most recent Consumer Price Index (CPI) for January showed year-over-year inflation of a mere 0.5% and this is well below the “medium-term inflation rate of 2%” that the BoC believes it must achieve to maintain price stability. Some bond-market investors have been betting that our economy’s current disinflationary trend will force the BoC’s hand, requiring it to lower rather than raise its overnight rate in response. This belief was bolstered by the Bank’s reference to “material excess capacity in the economy”.

Bond-market investors reacted to the BoC’s latest statement by pushing bond yields lower, believing that the Bank was projecting a more subdued growth and inflation outlook. But then the latest Canadian and U.S. employment reports were released on Friday and optimism quickly returned.

The headline Canadian and U.S. employment numbers were impressive.

Canada added 50,700 new jobs in February, with average hours worked increasing and average incomes rising faster than our rate of inflation. Most of the newly created jobs were for full-time private-sector employment and many of them were of the higher-paying service-sector variety.

The main concern associated with this strong employment report is that it doesn’t jibe with any of our other macro-economic data, which indicate that our economy has hit a soft patch and is dangerously close to stall speed. As a result, the experts I read think that this short-term disconnect cannot continue and they expect our employment numbers to soften in the coming months.

Conversely, the strong U.S. employment data are more consistent with other U.S. macro-economic data, which indicates that the U.S. economy is gaining momentum. For that reason I think it was the U.S. employment data, more than our latest domestic report, which pushed Canadian bond yields higher on Friday.

The U.S. economy gained 236,000 new jobs in February, exceeding consensus expectations of 165,000 new jobs for the month. The gains were spread across the private market in both the manufacturing and service sectors. Average hours worked and average incomes both rose, and the U6 unemployment rate, which is considered a broader and more accurate measure of U.S. unemployment, fell to 14.3% which is the lowest it has been since last summer.

While the latest U.S. employment report certainly offered some much-needed encouragement for our exporters, I don’t think the rally it triggered in our bond market last week will be sustained. That’s because this enthusiasm was in large part caused by the numbers exceeding the now ultra-low expectations bar for U.S. employment. Consider the following:

• The U.S. economy has lost approximately nine million jobs since the start of the Great Recession and despite record amounts of federal government stimulus for the last five years and counting, current U.S. employment has not recovered to anywhere close to its pre-recession levels.
• There have been 5.8 million fewer Americans working full time and 2.8 million more Americans working part time since the start of the Great Recession. This is consistent with a worrying long-term trend: higher-paying jobs being replaced by lower-paying jobs.
• The U.S. labour force participation rate, which measures the percentage of the total eligible work force that is currently employed, now stands at 63.5%. This is the lowest the participation rate has been in thirty years.
• Of the total U.S. unemployed, 40% have now been out of work for more than one year and chronically unemployed people are much harder to re-integrate into the work force.
• The U.S. economy will have to average the 236,000 new jobs we saw in the February employment report for the next year and a half in order to reach the U.S. Federal Reserve’s target of 6.5% unemployment by 2015 (and that assumes that the historically low participation rate remains largely unchanged). In other words, the U.S. economy still has a huge amount of labour capacity to absorb before its labour costs will be putting any significant upward pressure on inflation.

Bluntly put, I’m all for a little enthusiasm, but let’s temper it with a bit of the salt provided above.

Five-year Government of Canada (GoC) bond yields finished eight basis points higher for the week, closing at 1.38% on Friday. Spring market mortgage-rate competition between lenders was unaffected by last week’s bond yield volatility and five-year fixed rates are still widely available at rates below 3.00%. (Apologies to Federal Finance Minister Flaherty who is trying to convince lenders that five-year fixed-mortgage rates should stay above 3.00%, market forces and bond yields be damned.)

Variable-rate mortgage discounts were unchanged for the week and can still be found in the prime minus 0.40% to prime minus 0.45% range.

The Bottom Line: I think the latest round of investor optimism that was triggered by Friday’s Canadian and U.S. employment reports will be short lived. In the end, I believe that last week’s more cautious interest-rate commentary from the BoC will prove, in the fullness of time, to have provided us with a more telling indication of where mortgage rates are headed for the foreseeable future.