Will the U.S. Federal Reserve Finally Raise Its Policy Rate, and What Impact Will That Prospect Have on Canadian Mortgage Rates?

The hot question surrounding bond yields and mortgage rates these days is whether the U.S. Federal Reserve is going to raise its short-term policy rate, called the “funds rate”, later this year.

The Fed funds rate is essentially the most important interest rate in the global economy. In normal times, it provides the Fed with its most effective monetary policy tool for controlling U.S. inflation and growth rates because it serves as the base rate on which all other U.S. interest rates are priced, either directly or indirectly. In extreme circumstances quantitative easing (QE) can have a greater short-term impact over U.S. interest rates, but QE is only used as a temporary, emergency measure.

Thus, the Fed funds rate has a profound influence over the U.S. economy, which is the world’s largest. Given that bond yield movements in many other countries have a high correlation with U.S. bond yield movements, any change in the Fed funds rate initiates a cascading impact that permeates throughout the global economy. This impact is keenly felt in Canada, where our Government of Canada (GoC) bond yields have moved in lock step with their equivalent U.S. treasury yields since the start of the Great Recession, and this is why anyone keeping an eye on Canadian fixed mortgage rates should keep a watchful eye on the Fed’s policy guidance.

Now on to the question of the day: Will the Fed finally raise its policy rate for the first time since 2006?

At the moment, the market thinks that it will. In fact, bond traders who speculate on such things are now betting that the Fed will raise its funds rate in September. This belief is underpinned by steadily improving U.S employment data over the past year. Specifically:

• The U.S. economy has added more than 200,000 new jobs for eleven straight months, which marks its strongest period of new job creation in twenty years.
• That momentum has increased even further of late, with the data showing that U.S. economy added more than a million jobs over the most recent three months (after recent upward revisions to the initial November and December U.S. employment data estimates). This marks the best three-month run of U.S. job creation over the past seventeen years.
• One of the main criticisms of the improvements in the U.S. employment data has been that wages have not been growing along with the demand for labour, but that too is changing. U.S. wages have now grown by an average of 2.2% over the most recent twelve months, and while that may not seem like an impressive number at first glance, it is well above the 0.8% U.S. inflation growth rate, as measured by the Consumer Price Index (CPI) over the same period. This means that the purchasing power of the average American worker is now expanding, albeit at a modest pace, and this improvement is critical to the U.S. recovery because American consumers account for a very large and increasingly important part of overall U.S. GDP growth. Interestingly, the experts I read argue that wages are a lagging indicator and that the Fed will risk keeping its funds rate too low for too long if it uses average wage growth to determine when it should tighten U.S. monetary policy.

While there is no denying that the U.S. employment data have been improving, the contrarian in me is still skeptical about the market’s current bet on the Fed’s tightening timetable. Here are my concerns:

• The Fed has been saying that it needs to see improvement in the U.S. job market before it will raise its funds rate for the first time since the start of the Great Recession. But thus far, each time the employment data have reached the Fed’s publicly stated threshold, the Fed has simply moved the goal posts.
• The Fed has said that it wants to see inflation return to its 2% target before it tightens monetary policy, and that it will even tolerate inflation above its 2% target for a sustained period if the U.S. economy is experiencing healthy economic growth. With inflation now hovering at 0.8%, will the Fed shift its focus from employment data to the inflation target this time around, and change the goal posts instead of merely moving them?
• The U.S. dollar has surged of late, and this currency appreciation acts as a de facto form of monetary policy tightening. Economist David Rosenberg estimates that the sharp rise in the U.S. dollar has had the same economic impact as a 2.00% increase in the Fed funds rate. Furthermore, if the Fed raises the funds rate and U.S bond yields rise in response, as would be expected, the U.S. dollar should surge even higher, further exacerbating this effect.

Time will tell whether the Fed will raise its funds rate this year as the markets are now expecting, but in the meantime, let’s focus on how a Fed rise is likely to impact Canadian mortgage rates.

If you are in the market for a fixed-rate mortgage this year, expect plenty of rate volatility as bond-market investors adjust their bets on what the Fed will do in response to each new economic data point. If and when the Fed announces that it will raise its funds rate, expect U.S. bond yields to spike over the short term, and if past is prologue, GoC bond yields should rise in sympathy. Since our fixed-rate mortgages are priced on GoC bond yields, they could easily move higher as the Fed’s plans to tighten monetary policy become clearer.

Variable-rate borrowers will be much more insulated from this volatility because prime rates are priced on the Bank of Canada’s (BoC) overnight rate, which is controlled by the steady hands of its interest-rate setting committee. BoC Governor Poloz continues to insist that the Bank will not be beholden to U.S. monetary policy, and he has repeatedly predicted that the BoC will lag the Fed’s monetary policy tightening timetable. Canadian bond-market investors are betting that the BoC will actually cut its overnight rate again in the near future, so at this point, they believe him.

Five-year GoC bond yields rose by six basis points last week, closing at 0.79% on Friday. Five-year fixed-rate mortgages are offered in the 2.69% to 2.59% range, and five-year fixed-rate pre-approvals are available at rates as low as 2.79%.

Five-year variable-rate mortgages are available in the prime minus 0.65% to prime minus 0.80% range, depending on the terms and conditions that are important to you.

The Bottom Line: Markets continue to gear up for the possibility that the U.S. Fed will raise its funds rate in the latter part of this year. While I think this is still not a forgone conclusion, as the prospect draws closer it should heighten bond-yield volatility and could drive our fixed mortgage rates higher in response. Meanwhile, our variable mortgage rates should be much less affected by this speculation because prime rates are controlled by the BoC, which is expected to maintain its cautious approach for the foreseeable future.