The (U.S.) Elephant’s Latest Twitches and Grunts

Last Friday, U.S. Federal Reserve Chair Janet Yellen gave a much anticipated speech at the Jackson Hole Summit, an annual meeting of the world’s central bankers in Jackson Hole, Wyoming. Fed Chair Yellen covered a wide range of topics and her words were carefully parsed by market watchers around the globe for hints of what the Fed might do and when.

As a reminder, the Fed’s actions matter to Canadian mortgage borrowers because our economy is tightly linked to the U.S. economy. For example, Bank of Canada (BoC) Governor Poloz has long said that any sustainable Canadian economic recovery must be underpinned by increased demand for our exports, and we sell about 80% of those into U.S. markets. The BoC believes that a rise in export demand would trigger a rise in business investment, which would then lead to productivity enhancements and fuel a rise in average incomes. Because this virtuous, self-reinforcing cycle starts with increased U.S. demand for our exports and because changes in U.S. interest-rate policy have a material impact on U.S./Canadian exchanges rates, the Fed’s actions have a direct, and at times substantial, impact on our economic momentum.

More bluntly, the Canadian perspective of the U.S/Canada economic relationship was summed up well by former Prime Minister Pierre Elliot Trudeau, who once said that living next to the U.S. “is in some ways like sleeping with an elephant. No matter how friendly or temperate the beast, one is affected by every twitch and grunt.”

Speaking of those twitches and grunts, here are the highlights from U.S. Fed Chair Yellen’s market-moving speech last week, with my comments included:

• “The U.S. economy [is] now nearing the Federal Reserve’s statutory goals of maximum employment and price stability.” While the headline data show that the U.S. economy is close to reaching its technical definition of “maximum employment”, there are still several key areas of concern. For starters, average U.S. incomes aren’t rising nearly as fast as hoped and have at times barely outpaced overall U.S. inflation, benign as it is. The U.S. participation rate (which measures the percentage of working-age Americans who are either employed or who are actively looking for work) is still well below its long-term average, and while many American workers are technically “employed”, there is still an above-normal percentage who are considered “underemployed” (which means that they are working part time but would prefer to work full time). The price stability the Fed mentions comes as a mixed blessing as well. It is true that overall U.S. inflation growth is hovering at about 1% today, which is comfortably below the Fed’s 2% target, but I think that “price stability” is in a lower range than the Fed would like. It wasn’t too long ago that the Fed was worried about outright deflation and, while no central bank will admit it, history suggests that most of them will eventually use higher inflation as a way to deal with their massive debt loads.
• “I believe the case for an increase in the federal funds rate has strengthened in recent months. Of course, our decisions always depend on the degree to which incoming data continues to confirm the Committee’s outlook.” So the Fed thinks the odds of a rate hike have increased of late, but they will continue to monitor the incoming data. We have heard the Fed use similar wording many times since the start of the Great Recession. The Fed is now worrying about the instability risks that rise when a low-rates-forever mindset permeates the market. In an attempt to counteract this, it uses its rhetoric to keep the market guessing about rate-hike timing. It is a way to keep speculators in check, but frankly, at this point I’m surprised it still works. The Fed’s caveats that it will continue to “monitor the incoming data” and that the range of possible outcomes is “quite wide” lays the groundwork for it to walk back its hawkish tone at future meetings. If past is prologue, it will do this as soon as bond yields start to rise in expectation that Fed rate hikes are imminent. Wash, rinse, repeat (and try not to yawn when anyone is watching).
• Fed Chair Yellen provided a recap of the policy tools that the Fed used before and after the Great Recession of 2008. She described how the Fed’s basic policy toolkit worked fairly well in normal economic times, but then explained how the financial crisis forced it to adopt increasingly unconventional policies, with each new initiative designed to counteract the negative effects of the ones that came before. Rate cuts and quantitative easing led to paying interest on bank reserves, which led to increasing the availability of Fed reserve funds to a wider range of market participants, which led to large-scale bond purchases designed to drive down long-term interest rates and this effectively eliminated market-based price discovery for S. government bonds. After reading about this evolution, I was left with the image of a debt monster looking a lot like Frankenstein.
• Fed Chair Yellen speculated that, in future, the Fed may “may wish to explore the possibility of purchasing a broader range of assets”, leaving me to wonder if it might one day set the price of U.S. corporate bonds in the same way that it now effectively sets the price of U.S. government bonds. (Heck, the Bank of Japan is even buying equities now!) Fed Chair Yellen also speculated that the Fed may one day look at increasing its 2% inflation target, and while she was quick to add that this wasn’t something the Fed was considering at this time, I think it is inevitable. Heavily indebted economies almost always choose to inflate their debts away. (It is more politically palatable than the alternatives of default or austerity.)
• Fed Chair Yellen stressed that productivity growth is the key missing ingredient in the current U.S. economic recovery, reminding us that “stronger productivity growth would enhance Americans’ living standards”. Interestingly, and ironically, the Fed’s ultra-low policy rate is part of what is holding productivity back. Today, because the cost of capital is cheap, companies have often chosen to buy their competitors rather than to invest in productivity improvements that would make them more competitive. And because the cost of labour is relatively low, productivity is less important because it is cheaper and less risky to hire more workers than to invest in enhancements that make production more efficient over the longer-term.
• “Policymakers and society more broadly may want to explore additional options for helping to foster a strong economy” and “fiscal policy has traditionally played an important role in dealing with severe economic downturns”. Central bankers didn’t choose to become the market’s marginal price setters. In fact, their predisposition toward being the ‘silent hand’ probably makes them uncomfortable with being so prominently spotlighted. History will show that political intransigence forced them to use their ill-fitted monetary policy tools to compensate for a lack of a better and more coordinated fiscal response. Fed Chair Yellen’s quote above is a reminder that every central banker’s wish today is for political courage to take the place of interventionist monetary policies, with measures like: “improving our educational system and investing more in worker training; promoting capital investment and research spending, both private and public; and looking for ways to reduce regulatory burdens while protecting important economic, financial, and social goals.”

Financial markets responded to Fed Chair Yellen’s speech by bringing forward their bet on the timing of the Fed’s next rate rise from May of 2017 to December of 2016. While I expect that this was exactly the reaction that the Fed was hoping for, I doubt that it will end up pulling the trigger. There is just too much uncertainty, which is a word that has featured prominently in many of the Fed’s latest missives, and I don’t see the Fed tightening monetary policy until overall U.S. inflation is running above its 2% target for an extended period of time. Also, I am reminded of economist David Rosenberg’s recent observation that whenever the Fed has hiked its policy rate and then paused for at least six months, as it has now done, its next move has always been a cut.

Five-year Government of Canada bond yields rose five basis points last week, closing at 0.73% on Friday. Five-year fixed-rate mortgages are available in the 2.29% to 2.39% range, depending on the terms and conditions that are important to you, and five-year fixed-rate pre-approvals are offered at about 2.49%.

Five-year variable-rate mortgages are available in the prime minus 0.40% to prime minus 0.50% range, which translates into rates of 2.20% to 2.30% using today’s prime rate of 2.70%.

The Bottom Line: Fed Chair Yellen’s speech last week caused markets to move forward their expectations of when U.S. interest rates might next rise. Nonetheless, for the reasons outlined above, I doubt that the Fed will follow through on its jawboning any time soon. It  will therefore be a while yet before U.S. interest-rate movements put any material upward pressure on either our fixed or variable mortgage rates. Instead, think of last week’s Jackson Hole speech as just the latest twitching and grunting from the elephant that shares our economic bed.