U.S. Fed Chairman Bernanke Talks Bond Yields Down. Will Mortgage Rates Follow?

Last Wednesday, U.S. Federal Reserve Chairman Ben Bernanke made his first public comments since warning markets several weeks ago that the Fed could begin tapering its quantitative easing (QE) programs later this year.

Officially, the Fed Chairman’s speech was part of a conference being held by the National Bureau of Economic Research (NBER) and Mr. Bernanke’s topic was titled “A Century of U.S. Central Banking: Goals, Frameworks, Accountability”. Riveting stuff, I’m sure, but like the opening act at a Bruce Springsteen concert the speech itself was just a prelude to what people really wanted to hear. The main event came during the question and answer period when Chairman Bernanke commented on market developments since he cautioned investors three weeks ago that QE would not continue forever.

(You can watch the video here on CSPAN. The Q&A session starts at the 28-minute mark.)

Before I provide a summary of what the Chairman said and how the market reacted, let’s quickly review both how we got to this point and why Canadian mortgage borrowers should care about changes in U.S. Fed’s monetary policy:

• Since the start of the Great Recession, the Fed has adopted ultra-loose monetary policies which have included a 0% short-term policy rate and three rounds of QE that have expanded the Fed’s balance sheet from $870 billion in August 2007, to $3.5 trillion in July 2013. A staggering increase that some analysts believe could ultimately hit $9 trillion before QE is eventually wound up.
• The Fed’s main QE objective has been to suppress bond yields in the hope that this will stimulate growth and investment by lowering the cost of borrowing for U.S. consumers and businesses.
• While the Fed has been successful in lowering bond yields, these lower returns have significantly increased the risk that asset and credit bubbles will form. When bond yields are artificially suppressed, investors often take on increased levels of risk to achieve their accustomed returns, and borrowers who are encouraged by ultra-low rates to increase their debt burden are in danger of being overextended when interest rates eventually rise.
• When the U.S. Fed embarked on its latest round of QE, it said that this program would remain in place at least until the unemployment rate dropped to 6.5% and provided that inflation did not rise beyond the 2% range.
• On June 19, at the conclusion of the Fed’s latest policy meeting, Chairman Bernanke said that the pace of the U.S. economic recovery was improving and that the Fed could begin tapering its current QE program if that momentum continued. Markets reacted violently to this warning, pushing bond yields and borrowing costs sharply higher while the S&P 500 plunged by 5%.

That’s the situation we found ourselves in when Chairman Bernanke stepped to the microphone last Wednesday. But before we get to that, here’s a quick reminder of why you should care what Chairman Bernanke has to say If you’re a Canadian mortgage borrower:

• Our fixed-rate mortgages are priced off of Government of Canada (GoC) bond yields, which have had a 98% correlation with U.S. Treasuries over the past five years. If the Fed tapers its QE program and U.S. Treasury yields surge higher, higher GoC bond yields and higher Canadian fixed-mortgage rates will quickly follow.
• Our variable-rate mortgages are priced using the Bank of Canada’s (BoC) overnight rate, which is currently set at 1%, while the U.S. Fed’s comparable policy rate remains stuck at 0%. The BoC will find it very difficult to raise its overnight rate any higher until the U.S. Fed raises its policy rate because expanding the gap between these two rates would drive the Loonie higher against the Greenback and heap further suffering on our already beleaguered export-based manufacturers.
• Given that the U.S Fed isn’t likely to even think about raising its policy rate at least until its massive QE programs are completely unwound, I think it will be some time before Canadian variable-rate borrowers have much to worry about.
• Meanwhile, Canadian fixed-rate borrowers live and die with each new hint of guidance offered by the Fed on the timing of its QE withdrawal and/or each new related economic-data release.

With that in mind, here is what Chairman Bernanke said about the Fed’s ultra-loose monetary policies after he finished his prepared remarks at the NBER conference:

• While he was surprised by the market’s reaction to his comments, Chairman Bernanke felt that he had to remind investors that QE would not continue forever. He was concerned that investors would “drift away” from the Fed’s guidance and start operating under the assumption that QE would be “infinite”.
• The Fed is using its 0% policy rate and its QE programs as its two main policy tools. QE is being used as a way to provide short-term stimulus to the broader U.S. economy and the improvement the Fed wants to see before unwinding it “has further to go”. Meanwhile, the 0% policy rate is specifically trying to help lower the unemployment rate, and it will not be raised “at least until unemployment hits 6.5% [and] as long as inflation is well behaved”.
• A 6.5% unemployment rate is “a threshold, not a trigger”. Achieving 6.5% unemployment will merely provide a signal that it is “time to think about the situation anew”. On that point, Chairman Bernanke added: “Given that the unemployment rate understates the weakness of the labour market and given where inflation is, I would suspect that it may be well after we hit 6.5% before rates reach any significant level”.
• Chairman Bernanke said that he thinks the current U.S. unemployment rate of 7.6% “overstates the health of [U.S.] labour markets” and that both the current employment and inflation data are saying “that we need to be more accommodative”.
• There may be “gradual [and] possible changes in the mix of instruments” used by the Fed to fulfill its dual mandate of maintaining price stability and promoting full employment, such as reducing QE, but that shouldn’t confuse people about the overall thrust of policy the Fed’s policy, which will remain “highly accommodative.”
• “Higher accommodative monetary policy for the foreseeable future is what is needed in the U.S. economy.”

The markets reacted favourably to Chairman Bernanke’s comments, with stocks moving sharply higher while bond yields fell. Investor reaction was also tempered by the release of the Federal Open Market Committee (FOMC) minutes from the latest Fed meeting. This document revealed that there is still much debate among the FOMC’s members about when QE should be withdrawn. It supported the now growing belief that the Fed will be more cautious in its approach to stimulus withdrawal than was widely believed three weeks ago when Chairman Bernanke first reminded markets that the Fed’s stimulus would not last forever.

Five-year GoC bond yields fell by twelve basis points last week, closing at 1.75% on Friday. This will stem the tide of further rate increases and should lead to a tightening of the range of five-year fixed-mortgage rates on offer.

Five-year variable rates are currently offered at discounts as low as prime minus 0.60% (which works out to 2.40% using today’s prime rate). Despite the recent run-up in fixed rates, the BoC’s Mortgage Qualifying Rate (MQR), which is used to qualify variable-rate borrowers, has held steady at 5.14%.

The Bottom Line: Last week’s comments by U.S. Fed Chairman Bernanke provided further support to my view that the Fed will taper its QE programs more slowly than most market watchers are expecting. If I am proven right, both our fixed- and variable-mortgage rates should remain at ultra-low levels for the foreseeable future.