The U.S Fed Trades Short-Term Gain for Longer-Term PainSeptember 23, 2013
What Permanent QE Would Mean for Canadian Mortgage RatesOctober 7, 2013
When several euro-zone countries tottered on the brink of default, investors responded by pouring their money into Government of Canada (GoC) bonds, driving down these yields, on which our fixed-rate mortgages are based.
When the U.S. Federal Reserve announced that it would initiate quantitative easing (QE) programs to stimulate economic growth, investors once again sought out GoC bonds. And why not? They offered higher yields than equivalent U.S. treasuries; our federal government has the cleanest balance sheet in the G7; our federal deficit is manageable (and shrinking); and the printing presses at our central bank remain idle.
Then an eerie calm ensued.
Europe quieted down in time for the German election … but the euro-zone’s leaders didn’t use the lull to fix the structural problems that led to the initial financial crisis. That makes their next crisis all but inevitable.
The U.S. Fed’s stimulus programs have prolonged the U.S. economy’s slow-growth momentum … but every new dollar printed produces a diminishing benefit while fears about the U.S. Fed’s unprecedented balance sheet expansion continue to grow.
Japan’s three-pronged approach to pulling its economy out of its two-decades-long slump finally got its GDP ticking upwards … but this seems to have only temporarily drowned out that other ticking sound that can be heard from Japan. That would be the ticking of its colossally large debt-bomb.
Not surprisingly, as investor fears of sovereign default and stock market crashes began to fade, investors started rotating out of safe-haven bonds. In Canada, this caused GoC bond yields to rise and our mortgage rates quickly followed. On June 3, I wrote this post that explained why our mortgage rates were increasing and I made the case that this run-up would not last. I closed with this prediction:
I think this [bond yield] run up has been primarily caused by the growing belief among investors that the world economy’s tail-risk threats are subsiding but, in my view, the world’s largest economies continue to face significant challenges. For that reason, I think our bond yields will head lower again, and that history is likely to show that this was really just a brief period of calm before the next storm.
Markets are governed by only two primary forces: fear and greed. When fear takes the driver’s seat, investors care more about return of their capital than they do about the return on their capital.
Well, fasten your seat belts folks because, once again, fear is about to take the wheel.
While there are numerous simmering threats to our fragile global economic momentum that could boil over, none will tip investors back into full-blown fear mode faster than a sovereign-debt default. Both the U.S. and the euro zone are again flirting with this risk. To wit:
- In the U.S., House Republicans have refused to approve a much-needed spending bill unless both the President and the Democrat-controlled Senate agree to suspend funding for Obamacare. Fat chance of that, and anyway, this is just the warm-up fight. The real battle will be over the U.S. debt-ceiling limit, which needs to be raised by the middle of October to keep federal programs running. If the debt limit isn’t raised, U.S. GDP growth will stall and many experts think the U.S. economy could be tipped back into recession within a month. Once again, it appears that the threat of a U.S. debt default will be used as a political football in an ideological debate where at least some of the players involved seem willing to run the U.S. economy into the ground to make their point. If they do, the rest of the world will be forced to pay a steep price at an inopportune time. Very few countries have enough dry powder left in their fiscal and monetary policy arsenals to stave off the global damage that a U.S. default, or even the serious threat of one, would cause.
- Angela Merkel won re-election, and just in time, because Greece needs another bailout and Portugal is queuing up behind it at the German cash window. While Chancellor Merkel’s party won a near record 41.5% of the vote, her traditional coalition partner in parliament failed at the polls and that raises the prospect that the Chancellor will have less reliable support from the new coalition partners she must assemble to produce her majority. That support will be tested soon enough because the euro zone’s imperilled countries can’t wait much longer for their next bailout packages.
The U.S. threat is more immediate, but most observers still agree with Winston Churchill that Americans eventually do the right thing “after they have exhausted all the other possibilities”. That said, does anyone doubt that many House Republicans are determined to either repeal Obamacare or die trying?
The euro zone’s ongoing bail-out and default dance will probably be slower to get going again but for the reasons I listed in this post last year, I think the worst is yet to come. The euro zone’s march back into crisis mode has “inexorable” written all over it.
This is not to say that I think Canadian bond yields will move straight down from here. The U.S. Fed may have decided not to taper its QE programs at its most recent meeting but the spectre of this development still hangs over bond markets like the sword of Damocles. Early indicators suggest that the U.S. employment report for September, which is due out later this week, may be stronger than expected. If we see a surprisingly strong report, investors could recalibrate their taper timing projections and bond yields could once again surge higher. Over the coming weeks and months, however, I think that the sound and fury surrounding the taper will be drowned out by the more powerful and systemically important euro-zone and U.S. sovereign default risks.
Five-year Government of Canada (GoC) bond yields were twelve basis points lower for the week, closing at 1.88% on Friday. We have now seen a twenty-four basis point drop in the five-year GoC bond yield over the last two weeks but despite this, most lenders have not yet dropped their five-year fixed rates. While this delay is disappointing for fixed-rate borrowers, it is not altogether surprising. To borrow a well-known description of stock-price movements, mortgage rates also tend to take the elevator on the way up and the stairs on the way down.
Five-year variable rates are available in the prime minus 0.50% range, which works out to 2.50% using today’s prime rate of 3.00%. If you find any reasons why the Bank of Canada will raise its overnight rate (on which our variable rates are based) for the foreseeable future, would you please let me know? I keep looking for hints in the economic data but I still can’t find any.
The Bottom Line: In the short term, I think the latest round of U.S. budget brinkmanship will heighten uncertainty and push GoC bond yields lower. Over the longer term, I expect the slowly rekindling euro-zone crisis to eventually take the fear baton from Uncle Sam. Both developments mean that we should see lower fixed-mortgage rates on the horizon.