Is the U.S. Fed Making the Unthinkable Inevitable?
November 4, 2013Why Quantitative Easing Should Make Canadian Mortgage Borrowers Nervous
November 25, 2013
Market watchers were surprised last Friday when the initial U.S. and Canadian employment data for October came in stronger than expected, and bond yields rose on the news.
In today’s post I’ll summarize the latest employment reports, but more importantly, I’ll explain the implications of an obscure Fed research paper that was also published last week. This report suggests that U.S. employment data will have to climb much higher than markets are expecting before the Fed will consider altering its monetary policy.
Canadian Employment in October
The latest Labour Force Survey showed that our economy added 13,200 new jobs last month, which was higher than the 11,000 new jobs the consensus was expecting.
Those who considered this to be a strong report liked the fact that all of the net new jobs were in full-time positions. Average hours worked rose by 0.40%, which David Rosenberg estimates is equivalent to adding another 75,000 more jobs to our economic landscape. Average wages also rose by 0.40%, following a robust 1.8% increase in September. This latter change is positive because it means that wages are growing faster than prices (as measured by CPI), and that increases the purchasing power of the average Canadian.
Not all of the details behind the headline data were positive. While the public sector grew last month, the private and self-employment sectors shrank. Our federal and provincial governments still need to reduce their budgets in the long run so any uptick in the employment data that is led by public-sector growth can’t be sustained over the medium and long term.
We also lost another 6,400 manufacturing jobs last month, and these are the jobs that fuel additional, downstream employment growth. Tavia Grant at the Globe and Mail reports that our economy now has the second lowest level of Canadian manufacturing jobs since these records began in 1976.
In summary, while our latest employment report was a little better than expected and held some encouraging signs, it didn’t materially change our employment picture. Our economy is still struggling to create enough jobs to outpace the natural rate of our labour force expansion, and until that changes, our employment growth will not produce any positive economic impact of significance.
U.S. Employment in October
The latest U.S. employment data showed that employers shook off the budget and debt-ceiling drama in Washington last month and added a surprising 204,000 new jobs in October, with another 60,000 jobs added in revisions to the initial employment data from the prior two months. This was well above the 120,000 new jobs that the consensus was expecting and was in line with the most recent three-month average.
Private-sector employers added 212,000 new jobs and unlike in Canada, there was a surge in U.S. manufacturing jobs (+19k) and goods-producing employment (+35k). Average wages also rose by 0.50% in October, and this continues an encouraging trend that, as in Canada, shows U.S. earnings rising more quickly than official U.S. inflation.
Nonetheless, while the report was certainly stronger than expected, some market watchers tempered their enthusiasm by noting that the U.S. labour force participation rate declined again, from 63.2% to 62.8%, and that much of the related U.S. economic growth in October was the result of inventory expansion. When businesses increase spending to add to inventories, it creates a short-term growth surge, but if there is no follow-through demand from buyers, that momentum fades quickly. In such a scenario, inventory expansion merely shifts the employment benefits of future demand to the present and, as such, does not signal sustainable economic expansion.
While the latest U.S. employment report was a net positive, market watchers might want to think twice before using these data to recalibrate their estimates of when the U.S. Fed will taper its QE programs and eventually raise short-term interest rates. The Fed has a habit of moving the goal posts when its employment targets are met, and there is fresh evidence that this may happen again.
A new research paper that was published last week by William English, a senior Fed staffer, argues that before considering a shift in its monetary policy, the Fed should now wait until the U.S. employment rate drops to 5.5% rather than to the 6.5% level the Fed has repeatedly cited when offering guidance to markets. Interestingly, he bases this argument on the fundamental assumption that today’s record-low participation rate is a result of cyclical factors that can be overcome with appropriate levels of Fed monetary-policy stimulus. Personally, I subscribe to the counter argument that today’s ultra-low U.S. participation rate is in fact structural, instead of cyclical, and that the Fed’s aggressive monetary policy actions have achieved little of their desired impact. (Stay tuned for more about this in next week’s post.)
Given that U.S. and Canadian monetary policies are so closely linked, when the Fed shifts its tapering timing and/or its guidance on future short-term rate increases, there are major implications for Canadian mortgage borrowers. Any additional delays in either Fed policy should directly translate into extended ultra-low rates for Canadian variable-rate mortgage borrowers and new fixed-rate borrowers.
Five-year Government of Canada bond yields were six basis points higher last week, closing at 1.84% on Friday. Five-year fixed rates with excellent terms and conditions are now available in the 3.45% range and shorter-term fixed rates are also attractively priced.
Five-year variable rates are still about 1% cheaper than the equivalent five-year fixed-rate alternatives. All considered, I continue to think variable rates are the more compelling option for borrowers who are comfortable taking on the risk that rates could rise in the future.
The Bottom Line: Canadian mortgage borrowers should be forgiven for believing that the interest-rate deck remains stacked in their favour. When U.S. employment data are weak, bond yields fall as markets expect the Fed to delay tapering and keep U.S. short-term rates lower for longer. When U.S. employment data are strong, as was the case this month, the Fed hints that it will push back the goal posts that it uses to gauge its shifts in monetary policy. So, as perverse as it may seem, if bond yields continue to rise in response to the latest U.S. employment data, fear not, because the Fed will ride to the rescue. At least … for as long as the bond market will allow it to do so …