Happy ThanksgivingOctober 13, 2015
The Latest Bank of Canada Report Implies Our Next Rate Hike May Come in Mid-2017October 26, 2015
I have subscribed to the view that our mortgage rates aren’t likely to head materially higher since the start of the Great Recession and over time, that view has become increasingly mainstream. But before we all start popping champagne corks in celebration, now seems like a good time to highlight the rising economic costs (and risks) that develop when borrowing rates are kept too low for too long.
Low interest rates have been a boon to Canadian mortgage demand so it may seem surprising to read a post written by a mortgage planner about the five ways that those low rates are hurting our economy. But if monetary policy is kept loose for too long, which many observers think has already happened, today’s cheap money may well prove to have been too much of a good thing. In the same way that chocolate tastes good in the beginning but gives you a tummy ache if you overindulge, ultra-low rates give our economy an initial boost but can then create rot and excess if left in place for too long.
Here are five examples of how ultra-low interest rates are now hurting our economy:
- They create zombie companies – Over abundant liquidity gives inefficient businesses access to funds that help keep them alive when they would either die or be forced to reinvent themselves in more normal times. These companies tie up resources such as labour and absorb market share that would otherwise go to their more successful competitors. Creative destruction is an essential part of capitalism and cheap money prevents this painful but necessary form of economic Darwinism from taking place.
- They lead to higher debt levels and higher borrowing costs, which crowd out other forms of investment – When both governments and companies borrow too much, they devote precious resources toward servicing debt and are forced to reduce expenditures on more productive types of investment. This is why higher debt levels correspond with falling productivity and lower growth rates. And then, when rates eventually head higher, these inefficient allocations are further exacerbated.
- They can fuel asset bubbles – To use real estate as an example, when mortgage rates are dirt cheap, everyone can afford to borrow more. If there is no change in supply, it doesn’t take long before prices start to rise as buyers compete for limited housing stock. Not surprisingly, there is a very high correlation between falling interest rates and rising house prices. Canadians see this most notably in cities like Vancouver and Toronto where supply is difficult to increase because of land or regulatory restrictions. While I don’t subscribe to the view that these cities are on the verge of house price collapses (sorry Garth), I do think that the potential for destabilizing price adjustments will rise if rates stay at ultra-low levels indefinitely.
- They force vulnerable retirees to make riskier investments unsuited to their stage of life in an effort to maintain adequate returns – Many retirees rely on investment returns to cover living expenses. Cheap money lowers these returns and forces them to make the very difficult choice to either draw down their principal and shrink their nest eggs or buy riskier investments in a chase for higher yields. Without employment income and without many years to build their portfolios back up, it is far more difficult for retirees to recover any losses incurred from these riskier investments.
- They make it very difficult for pension funds to meet their future obligations – Pension funds are required to invest the bulk of their portfolios in longer-term bonds, because they have always been deemed safe by regulators and because they must match the duration of their assets with the timing of their future payout obligations. But today’s ultra-low bond yields make the contribution rates that were used to build these portfolios inadequate, because they were calculated based on the assumption that bond yields would be much higher than they are today. Over time, an increasing percentage of these portfolios are rolled into bonds priced at ultra-low yields, and in turn, the potential negative impact from a drop in the principal value of these bonds when yields turn higher is incrementally magnified. This makes pension funds more vulnerable at a time when they are already grappling with significant challenges. The number of retirees is increasing at the same time that people are living much longer than they used to. If today’s ultra-low bond yields ultimately prevent these funds from adequately providing for their retirees, our government will have no choice but to rely on tax payers to make up the difference.
Our central banks aren’t talking about these risks, but we should appreciate them nonetheless.
Five-year Government of Canada bond yields fell three basis points last week, closing at 0.84% on Friday. Several lenders have recently raised their five-year fixed rates, but you can still find them in the 2.49% to 2.59% range. Five-year fixed-rate pre-approvals remain at rates as low as 2.64%.
Five-year variable-rate mortgages are available in the prime minus 0.65% to prime minus 0.75% range, depending on the size of your mortgage and the terms and conditions that are important to you. That said, these deeply discounted rates are now less widely available and may not be around for much longer.
The Bottom Line: It is understandable that mortgage borrowers consider it good news when forecasters predict that mortgage rates are likely to remain at today’s ultra-low levels for the foreseeable future. But an extended period of ultra-low rates also creates negative impacts that weaken our economy, and over time, leave it less well equipped to absorb higher borrowing costs when rates do eventually rise. These risks need to be understood because, after all, we are not just mortgage borrowers. We are also employees and entrepreneurs, taxpayers, savers, and investors. Before we get too complacent about today’s lower-rates-for-longer environment, it is worth remembering that there is no such thing as a free lunch.