When the Bank of Canada (BoC) met on September 4, the Government of Canada (GoC) five-year bond yield stood at 1.12%, which marked a 52-week low.
At the end of that meeting the Bank surprised market watchers when it released a more bullish than expected policy statement, and since then, our bond yields have moved steadily higher. To wit, the five-year GoC bond yield closed at 1.51% last Friday after its sharpest five-day increase in well over a year.
While on first pass the cause and effect of our recent bond-yield surge may seem clear, a closer look suggests otherwise.
Last week the Bank of Canada (BoC) left its policy rate unchanged, at 1.75%, as the consensus expected, but it also surprised market watchers by maintaining policy-rate language that gave no hint of rate cuts to come.
Most analysts believed that the Bank would shift to a more dovish tone at last week’s meeting and pave the way for a rate drop later this year. Instead, the Bank assessed that its policy rate was still “appropriate” based on current conditions.
For my part, in the lead-up to this meeting I argued that the BoC should cut its policy rate now, and I reiterated that belief even after we learned that overall inflation rose to the Bank’s 2% target in July.
My conclusion, based on the Bank’s oft-stated goal to anticipate the road ahead, was that it should cut its policy rate as a precaution (because it takes time for policy-rate changes to impact our economic momentum). But the Bank decided not to cut, and it didn’t even adopt more dovish language as a milder form of monetary easing.
Today most of the developed world’s central banks worry about having too little inflation if they are lucky and outright deflation if they aren’t. (Central bankers worry about deflation, which is an outright decline in average prices, because their monetary policy tools are much better suited to tamp down inflation than to reignite it.)
Bond-market investors also see deflationary headwinds gathering, and that partly explains the recent breathtaking rise of global bonds with negative yields, which now total around $17 trillion (and counting).
Against that backdrop, the Bank of Canada (BoC) is in an enviable position.
There are now almost $17 trillion worth of bonds trading at negative yields, up $4 trillion this month alone.
(Note: anyone buying a bond with a negative yield and holding it to maturity will receive back less than they paid for it.)
Here are some other examples of the “interesting times” in which we live:
At its last meeting, in July, the Bank assessed that the Canadian and U.S. economic trajectories were converging. Canadian economic momentum was recovering after a slump, and U.S. economic momentum was slowing after a period of above-potential growth. Against that backdrop, the BoC argued, divergent monetary-policy actions were justified.
It is also true that the Fed raised its policy rate by a quarter point nine times during its most recent tightening cycle while the BoC hiked only five times. Even after the Fed’s most recent cut, its policy rate still operates in a range that is 0.25% to 0.50% higher than the BoC’s policy rate.
In that context, I agree that the BoC shouldn’t run out to match the Fed’s next move as long as the Loonie isn’t soaring against the Greenback (which right now, it isn’t). But the Bank has other reasons to cut its policy rate at its next meeting, regardless of what the Fed is doing.
The Fed also announced that it would end its balance-sheet reduction program two months sooner than expected (which is another kind of monetary-policy easing).
Interestingly, financial markets did not respond to this news as expected.
When the Fed lowers its policy rate, borrowing costs fall and this usually stimulates economic growth. Investors normally respond by increasing their holdings in cyclically sensitive assets, like stocks and commodities, and by reducing their exposure to the U.S. dollar (which would be expected to weaken in relation to other currencies).
This time around, in each case, the opposite happened. In the immediate aftermath, equity and commodity prices fell and the Greenback rose.
Put another way, financial markets responded to the Fed as if it had actually raised its policy rate last week. Why?
Consider that today more than 13 trillion USD worth of bonds, mostly from Europe and Japan, trade at negative yields. (When a bond has a negative yield, it means that investors end up with less than they started with by the end of the term.)
The obvious question that follows is why anyone would buy a bond with a negative yield.
Simply put, the market is always governed by either fear or greed. When fear is winning out, as in the case of the bond market today, the safe return of capital takes priority over the return on capital.
Here are five fears that are driving investors into negative bond yields:
Last week the Bank of Canada (BoC) lowered its Mortgage Qualifying Rate (MQR) from 5.34% to 5.19%, marking the first MQR decrease since September 2016.
In today’s post I’ll offer a quick review of how the MQR works before highlighting some fundamental and persistent design flaws in this critically important benchmark.
Let’s start with a basic explanation of how the MQR is used during the mortgage qualification process:
- If you’re in the market for a five-year fixed-rate mortgage today, you’re looking at rates a little below 3%, and if you’re looking for a comparable five-year variable-rate today, those rates are typically about 0.20% to 0.35% higher (a sign of the strange times in which we live).
- Even though the rate on your five-year mortgage is likely to be a little above or below 3%, lenders will use the MQR rate (now 5.19%) to qualify you for the amount you want to borrow. This “stress test”, as it is commonly called, is designed to ensure that you can afford to renew your mortgage at higher rates down the road.
- If you are putting down less than 20% of the purchase price of a property, you are always qualified using the MQR.
- If you are putting down more than 20% of the purchase price of a property, or refinancing/renewing your existing mortgage, your application will be qualified using the greater of the MQR, or the rate on your mortgage plus 2%. (Since most of today’s rates are lower than 3.19%, the vast majority of these borrowers are also now being qualified at the MQR).
The MQR drop of 0.15% only adds a few thousand dollars of purchasing power to each borrower’s bottom line, so that news alone doesn’t warrant much ink. But with the MQR back in the headlines, now seems like a good time to take another look at its fundamental design flaws, none of which have been addressed by our policy makers since its introduction.
Once again, “uncertainty” was the main theme pervading both the Bank’s policy statement and its accompanying Monetary Policy Report (MPR).
Somewhat surprisingly, the Bank, which has tended to consistently err on the optimistic side of its forecasts, offered a cautious assessment of our recent run of stronger than expected data. The consensus was ready for the Bank to sound a hawkish tone, but the current backdrop of ongoing trade wars and slowing economic momentum both in the U.S. and globally led to caution winning out.
In today’s post I’ll provide highlights from its latest communications to explain why.
When times are tough and it weakens, our exports become more competitively priced and the costs of our imports rise, increasing the appeal of domestic alternatives (where available). This naturally occurring process provides stimulus that has far fewer side affects than alternatives like deficit spending, rate cuts and/or unconventional monetary policies.
When times are good, the Loonie strengthens. Our exports become less competitively priced and the costs of our imports fall, shifting demand away from domestic sources and towards foreign alternatives. This helps to relieve inflationary pressures that typically build during extended periods of strong growth, with fewer negative side effects and a more nuanced impact than Bank of Canada (BoC) rate hikes.
Not every economy enjoys access to this useful tool.
To wit, the U.S. futures market is now pricing in 100% odds of a 0.25% rate cut when the Fed next meets on July 31, and it is pricing in 68% odds that the Fed will lower its policy rate by 0.75% (or more) by the end of this year.
Here are five highlights from the Fed’s latest update:
Recent U.S. economic data have shown slowing momentum in many key areas, such as employment growth, consumer spending, manufacturing output, export sales and home sales. Not surprisingly, the consensus now forecasts that U.S. GDP will slow sharply from 3.1% in the first quarter to around 1.8% in the second quarter on an annualized basis.
This loss of momentum comes after nine quarter-point interest rate increases by the U.S. Fed that began in December 2015. As with Bank of Canada (BoC) moves, the Fed’s rate hikes take time to assert their full impact. If we use the common assumption that this process takes an average of two years, consider that thus far, five of the Fed’s nine hikes have been on the books for less time than that.
The current U.S. economic expansion is about to become the longest in U.S. history, but the Fed’s aggressive monetary-policy tightening isn’t the only cause for concern.
This is a phenomenon that doesn’t occur very often. In normal markets, longer term interest rates are higher than shorter term rates. A yield-curve inversion happens when the yields offered on longer-term bonds drop below the yields offered on shorter-term bonds.
At first glance, this is counterintuitive. Why would I buy a bond that ties up my money for longer and also gives me a lower return?
Well … since you asked …
In its accompanying statement, the Bank offered its latest take on the incoming data with specific emphasis on “developments in household spending, oil markets, and the global trade environment”.
In today’s post I’ll break down the BoC’s observations and offer my take on how these three key areas are evolving.
First, some background.
The Bank of Canada (BoC) recently reminded us that its primary mandate is to keep inflation “low, stable and predictable”, even if doing so “may create side effects that make the economy vulnerable to new shocks.”
Given that, anyone keeping an eye on mortgage rates should be paying closing attention to the inflation data, the latest of which were released by Statistics Canada last week.
Here are five highlights: