Canadian Mortgage Rates May Be Headed Even Lower

There is widespread speculation that the European Central Bank (ECB) will launch its own version of full blown quantitative easing (QE) on Thursday of this week, and if that happens, it will have a direct impact on Canadian mortgage rates.

You may find it hard to believe that yet another central bank will double down on the belief that the problem of too much debt can be solved by adding a lot more of it. But ECB President Mario Draghi has few alternatives left at this point, and to quote Bernard Baruch, “If all you have is a hammer, everything starts to look like a nail.” Besides, President Draghi has yet to make good on the promise he made in July 2012 to do “whatever it takes” to preserve the euro, which he followed with his best Clint Eastwood impersonation by adding, “Believe me, it will be enough.”

In this case, the canary in the coal mine was the Swiss National Bank (SNB), which announced last week that it would remove the cap on the exchange rate between the Swiss franc and the euro that has been in place for more than three years. This cap was used as a way of defending the franc from becoming over-valued against the euro, after it had surged higher in the summer of 2011 as investors flocked to it as a safe-haven currency. The SNB responded by announcing that the franc would not be allowed to rise above 1.20 against the euro, and the Bank then printed new francs and used them as needed to buy enough euros in the open market to ensure that this exchange-rate cap was preserved.

The market response to the SNB’s announcement was dramatic – the franc surged higher and Swiss government bond yields plunged until they went negative all the way out to the ten-year term. That means that investors are now willing to pay for the privilege of lending to the SNB for the next decade just to enjoy the relative safety of the Swiss franc. But this reaction, painful as it will be over the short term for the Swiss economy because their sharply rising currency makes their economy less competitive, would have been largely expected. This leads me to conclude that when Swiss policy makers looked at the depth of the abyss into which the good ship ECB was about to steer itself, removing the cap was deemed less painful than continuing to follow the ECB along its anticipated path.

As we await the ECB’s imminent announcement, the other important question that we will finally answer this week is whether QE can even provide short-term relief to the euro zone at this point. In its expected form, the ECB will effectively print euros and use them to buy up euro-zone sovereign bonds, creating more fake demand in order to drive down their yields. But what if the announcement doesn’t have an impact and euro-zone sovereign bond yields don’t fall? There is an old investor’s adage that you buy the rumour and sell the fact, and if that applies in this case, then the ECB’s QE move may already be ‘in the price’ of euro-zone bond yields.

If that is true, then might we see a different market response? What if investors don’t think that the ECB’s plan goes far enough and instead deem it too little, too late? What if the ECB tries a shock-and-awe approach that spooks markets, stoking fears that the ECB has reached a point of desperation? If bond yields rise after the ECB’s announcement, will investors conclude that Emperor Draghi isn’t wearing any clothes, undermining the ECB’s credibility and rendering his powers of verbal persuasion impotent?

I expect a lot of volatility this week as uncertainty about the ECB’s QE plan, and the market’s reaction to it, rises. If past is prologue, this should drive down Government of Canada (GoC) bond yields, on which our fixed-rate mortgages are priced. Last week the bellwether five-year GoC bond yield set a new all-time low and could easily drop below 1% if demand for safe-haven assets surges in response to the ECB’s announcement.

Of course, at some point investors will start to question how all of this sovereign debt will ever be repaid, and that could turn them against this asset class altogether. When and if (on second thought … probably more ‘when’ than’if’) that day comes, all bond yields would be expected to rise, but for now, GoC bonds should benefit from their perceived status as the proverbial ‘prettiest horse in the glue factory’.

Five-year GoC bond yields plunged twelve basis points last week, closing at 1.10% on Friday. Lenders are finally dropping their fixed-mortgage rates, but this is only happening slowly and so far, these adjustments have merely brought higher-priced lenders in line with their more competitive counterparts. As such, five-year fixed-rate mortgages are offered in the 2.79% range, depending on the terms and conditions that are important to you, and five-year fixed-rate pre-approvals are now offered at 2.89%.

Meanwhile, five-year variable-rate mortgages are still available in the prime minus 0.65% to prime minus 0.80% range.

The Bottom Line: We should see plenty of bond-yield volatility in the lead up to the ECB’s announcement this Thursday. Barring a global bond-market panic, this volatility should help keep the GoC five-year bond yield at today’s microscopic levels, and could easily push it lower still. For better or for worse, we live in interesting times.