How Will the Latest U.S. Rate Hike Impact Canadian Mortgage Rates?
Monday Morning Interest Rate Update for October 1, 2018
The Fed’s policy-rate movements are noteworthy to Canadians because our two economies are so deeply integrated and because the U.S. economy is about nine times bigger than ours. The Fed moves rates in response to changing U.S. economic conditions, and given that the Canadian economy tends to track the U.S. economy over time, the Fed’s actions can act as a bellwether for anyone keeping an eye on Canadian mortgage rates.
To that end, here are the key highlights from last week’s Fed meeting:
- The Fed’s policy-rate range was raised from 2.00% to 2.25%. (For context, the BoC’s policy rate currently stands at 1.5%.)
- The Fed raised its forecasts for U.S. GDP growth from 2.8% to 3.1% for 2018, and from 2.4% to 2.5% for 2019. Its previous estimate for GDP growth in 2020 was left unchanged at 2.0%.
- The Fed observed that “the labour market has continued to strengthen and that the economy has been rising at a strong rate”. The Fed also expressed confidence that U.S. inflation would continue to hover in the 2% range and said that it did not yet see evidence that recently enacted trade tariffs have impacted prices.
- The Fed’s most noteworthy change was the removal of the word “accommodative” when describing its current monetary policy stance in its press statement. Market watchers interpreted this as a sign that the Fed would slow the pace of its rate hikes, but U.S. Fed Chairman Jerome Powell subsequently clarified that the wording change was merely an acknowledgement “that policy is proceeding in line with our expectations”.
- The Fed is forecasting that it will raise its rate by another 0.25% when it meets in December, three more times throughout 2019, and then once more in 2020. (Interestingly, and by way of contrast, the futures market is pricing in only two more Fed rate hikes between now and the end of 2019.)
Now let’s draw out some implications for the Canadian economy and our mortgage rates:
- While current U.S. economic momentum is the strongest it has been since before the Great Recession, that strength is primarily due to massive tax cuts and stimulus spending – initiatives that have pushed the U.S. federal government’s budget deficit to a level that is typically only reached during recessions. While all this stimulus has created a short-term sugar high for the U.S. economy, it has also fuelled a rise in inflationary pressures that are likely to grow and make their way north of the 49th
- On a related note, U.S. job growth has been strong of late, but most of the recent hiring has been concentrated on workers who have no more than a high-school education, while companies in need of more educated workers are reporting chronic labour shortages. Not surprisingly against that backdrop, average U.S. wages are now rising at their fastest rate in the past ten years (2.9%) and this trend is also stoking U.S. inflationary pressures.
- The recent U.S. tax cuts and stimulus spending initiatives have forced the Fed to continue along an aggressive rate-hike path in an effort to keep U.S. inflation under control. If the Fed continues to raise rates as expected, the U.S. yield curve is likely to invert by mid-2019. (Note: A yield curve inverts when short-term yields are higher than long-term yields.) The U.S. yield curve has inverted thirteen times since 1950, and on ten of those occasions, a U.S. recession followed within the next six to twenty-four months. If the Fed continues to hike rates as expected, the BoC is likely to continue raising as well, albeit at a slower pace. If/when the U.S. economy subsequently falls into recession and the Fed pauses and/or cuts rates, expect the BoC to again follow its lead.
- As noted above, the Fed removed the word “accommodative” from its most recent policy statement, but at the same time, it moved its median neutral rate up from 2.875% to 3%. (Note: the neutral rate is loosely defined as the policy rate that is deemed to be neither accommodative nor restrictive to economic growth.) This increase, although small, confirms the Fed’s belief that it has more incremental room to raise rates. That matters to Canadian borrowers because when the Fed moves its policy rate, it gives the BoC more leeway to do the same by altering the relative impact of BoC policy-rate changes on the critically important Canada/U.S. exchange rate. Fed rate raises give the BoC the flexibility to hike without causing the Loonie to surge against the Greenback, whereas Fed rate drops give the BoC room to lower without causing the Loonie to sell off against the Greenback.
- As also noted above, the Fed said that it hasn’t yet seen evidence of trade tariffs hurting the U.S. economy because inflation has not yet been noticeably impacted, but the U.S.’s trade-war pain may materialize elsewhere. For example, China is the largest foreign holder of U.S. treasuries ($1.18 trillion total) and if it cuts back sharply on its U.S treasury purchases, or starts selling them instead, U.S. bond yields could spike higher. That impact would be magnified in the current environment because the world’s other largest central banks are already reducing their U.S. treasury holdings at the same time that the U.S. federal government is issuing eye-watering amounts of new treasuries to pay for its recent profligate spending. China would suffer its own economic pain if it started dumping U.S. treasuries, but when trade wars get ugly, adversaries try to hit where it hurts most. While this outcome appears unlikely at present, if a Chinese sell off of U.S. treasuries caused a spike in U.S. bond yields, Canadian bond yields (and our mortgage rates) would likely get taken along for the ride.
The Bottom Line: The Fed will likely continue raising rates through the end of 2019, largely to stem inflationary pressures that are being stoked by the U.S. federal government’s ill-advised tax cuts and profligate spending. If the Fed isn’t able to stave off rising U.S. inflationary pressures over the near term, we are likely to import them, and if we do, that will accelerate the BoC’s rate-hike timetable. Over the medium term, the Fed’s aggressive tightening timetable may well tip the U.S. economy into recession, and if that happens, expect rates on both sides of the 49th parallel to then change direction and move lower.