Canadian Mortgage Rates Will Inevitably Rise … But When?

Today’s consensus on mortgage rates goes something like this: Central banks around the world are printing money like crazy in an attempt to stimulate (and reflate) their economies and to keep their governments (and in many cases their banks) from going broke. All of this ‘new money’ will eventually lead to higher inflation and when it does, higher mortgage rates will inevitably follow.

I agree with this general premise but it omits the most important detail – when.

While the Bank of Canada (BoC) and many prominent Big Five Bank economists have until recently been warning Canadians that higher mortgage rates could be just around the corner, I have consistently subscribed to the view that this day of reckoning will actually arrive later than most believe.

Today, let’s look at the impact (or lack thereof) that the U.S. Federal Reserve’s actions have had on the U.S. economy over the last several years – it’s a key element in my ‘lower-for longer’ view. I am focusing on the U.S. example because the U.S. and Canadian economies (and monetary policies) are tightly linked and if the U.S. economy experiences significantly higher inflation, we will import it.

For starters, it may be splitting hairs but technically the U.S. Fed isn’t actually ‘printing’ new money. Instead, it is expanding its balance sheet by increasing its purchases of U.S. treasuries which it typically buys from U.S. banks. That action increases each bank’s reserves but has no impact on the amount of money that is actually circulating in the economy. If the Fed wants to increase the supply of money circulating in the real economy it needs U.S. banks to act as the transmission mechanism, and it is here that the first breakdown in its master plan is occurring.

Despite its best efforts, the Fed has not increased either the banks’ appetites for lending, or consumer appetites for borrowing. When once asked about how to deal with this specific problem U.S. Federal Reserve Chairman Ben Bernanke famously said that if the banks wouldn’t start lending more he would drop money from helicopters directly into consumer’s wallets, earning him the nickname ‘Helicopter Ben’.

The Fed has been successful in engineering a massive increase in U.S. bank reserves over the last five years, causing the U.S. monetary base to increase by 250% from $840 billion to nearly $3 trillion over that period. But the rate at which banks convert reserves into money that is deployed into the economy, called the money multiplier, has fallen sharply over that same period. The net result is that the amount of money that is actually circulating in the real economy, referred to as the money supply, has increased by only 35% since 2008.

Now 35% is a lot less than 250% but a 35% increase in the money supply is still significant. If all else had remained equal, this might well have been enough to get things moving again. But other elements have been changing as well. Most importantly, the U.S. economy has seen a corresponding decrease in the velocity of money.

The velocity of money is a measure of the rate at which money circulates, or changes hands, in an economy. In simple terms, when money is circulating quickly it corresponds with increasing demand and in this environment, inflation rises. When the rate at which money changes hands slows, this corresponds with falling demand and creates a headwind that can cause disinflation, or even outright deflation.

The way that money is spent is arguably the primary determinant of its velocity (and of whether it leads to further growth). When a business borrows money to expand production or to increase productivity, this money is invested in order to produce income that can then be used to repay its debt. This stimulates growth and creates positive knock-on effects for the broader economy (by increasing ongoing demand for raw materials and labour, for example.)

Conversely, when consumers or governments borrow to finance immediate consumption this money provides no lasting benefit and produces no ongoing income that can be used to service outstanding debt. Worse still, as this type of debt accumulates it crowds out other more productive demand-generating uses of borrowed capital, acting as a drag on economic growth.

To put the current U.S. economic backdrop in context, consider that the velocity with which money now circulates in the economy has reached a six-decade low. And this has happened at the same time that U.S. growth rates have averaged 1.8% over the last thirteen years (the lowest average growth rate over a decade or more since the Great Depression).

The powerful forces described above have so far counteracted the U.S. Fed’s quantitative easing (QE) programs and as private and government debt levels continue to rise, both the money multiplier and velocity of money should slow further. For these reasons, while I agree that we will see higher inflation (and mortgage rates) at some future point, I don’t think the Fed’s QE programs are necessarily a threat to near- or even medium-term future inflation.

Government of Canada (GoC) five-year bond yields were unchanged for the week, closing at 1.18% on Friday. Five-year fixed-rate mortgages are widely available in the sub-3% range and the most aggressive rate promotions are being offered to high-ratio borrowers. While this may sound counter-intuitive, borrowers who have less than 20% equity in their property are required to pay for high-ratio mortgage insurance and this makes their loans cheaper to securitize. Lenders pass some of that savings back to high-ratio borrowers with additional rate discounting (usually five basis points). Notwithstanding this, borrowers with more than 20% equity in their homes still enjoy a lower overall borrowing cost because they do not have to pay to have their mortgages insured.

Five-year variable rates are currently available in the prime minus .40% to .45% range (which works out to 2.55% to 2.60% using today’s prime rate).

The bottom line: The U.S. Fed’s unprecedented balance sheet expansion has not yet triggered the higher economic growth the Fed hoped for – or the inflation that most pundits have rightly warned us will inevitably arrive at some future date.

Growth has been stifled in part because so much of today’s borrowed money is being used to finance immediate consumption, instead of productive investment. This is an unsustainable trend. And the Fed can only indirectly influence the supply and velocity of money that is actually circulating in the U.S. economy. If U.S. banks don’t want to lend and U.S. consumers don’t want to borrow, the Fed can only watch and wait.

The combination of these factors underpin my view that inflation in both the U.S. and Canada, and by association our mortgage rates, should remain at or near current levels for longer than the BoC and most economists are predicting. Unless Helicopter Ben wants to try firing up his rotors – then all bets are off.