The Loonie Rides to the RescueJanuary 27, 2014
Will Mortgage Rates Be Impacted By the Latest Canadian and U.S. Employment Reports?February 10, 2014
This matters to Canadian mortgage borrowers for several reasons:
- U.S. and Canadian monetary policies are tightly linked, making it highly unlikely that the Bank of Canada (BoC) will raise its overnight rate at least until the U.S. Fed hikes its equivalent Federal funds rate. Since the U.S. Fed has repeatedly said that it will not even consider raising the Fed funds rate until it has completely unwound its QE programs, the timing of this withdrawal acts as a kind of distant-early-warning system for Canadian variable-rate borrowers.
- The U.S. Fed taper is expected to strengthen the U.S. dollar and if the Loonie continues to depreciate against the Greenback, this will provide additional stimulus for our economy, particularly for our export-based manufacturers (which I wrote about last week).
- The taper’s impact on our economy goes beyond monetary policy and exchange rates. For example, if QE is allowed to continue for too long it could fuel higher-than-expected U.S. inflation, which we would inevitably import over time. This would force the BoC to raise its overnight rate in response. Alternatively, if the withdrawal of QE pushes U.S. bond yields up, Government of Canada (GoC) bond yields, which move in lock step with their U.S. counterparts, would move higher and trigger a rise in our fixed-mortgage rates.
Here are the highlights from the Fed’s press release that included the most recent tapering announcement:
- The Fed acknowledged the weak December U.S. employment data but expressed confidence in the broader U.S. labour market recovery, saying that “labor market indicators were mixed but on balance showed further improvement.” This implies that the Fed saw the most recent employment data as an anomaly that was impacted largely by seasonal factors, although a poor January jobs report could quickly alter that view.
- The Fed made it clear that it will respond flexibly to changes in the U.S. economic outlook, saying that “asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.” That means that we should continue to expect bond-yield volatility as markets react to each new economic data release and try to interpret how it will affect the Fed’s QE tapering timetable.
- “The Committee today reaffirmed its view that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens.” Variable-rate borrowers take note: the Fed is reiterating that it will not raise its fed funds rate until well after QE has been completely unwound, and this bolsters my view that your rates shouldn’t be going up for some time yet.
- “The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.” In other words, Fed policy is still being guided by fears over deflation, which it mitigates with loose monetary policy, as opposed to concerns about higher inflation, which it mitigates with tighter monetary policy.
- The Federal Open Market Committee (FOMC) vote to continue tapering was unanimous for the first time since June 2011. Some thought that had more to do with giving Federal Reserve Chairman Bernanke a proper send off at his last Fed meeting, as opposed to there being real convergence of FOMC committee member viewpoints. We should get a better idea of where the FOMC’s four newly minted voting stand at the next Fed meeting on March 18.
Now that the Fed has followed through with its second round of tapering, the consensus is that it will continue ratcheting down its QE programs until they are completely unwound by the end of this year. Here are a few reasons for why I think that timetable is optimistic:
- In a recent article, economist and market analyst Greg Weldon estimated that the U.S. treasury will have to issue $500 billion in new debt to cover the U.S. federal government’s budget deficit for this year, to say nothing of the nearly $3 trillion in maturing U.S. government debt that will have to be rolled over in 2014. Today, the Fed buys almost all of the newly issued U.S. treasury debt so when it withdraws (tapers) its support for U.S. bonds, who will become the marginal buyer of new U.S. debt at anything close to today’s low yields? If U.S. bond yields move higher, as I think they inevitably will if the Fed continues to withdraw its support, will the Fed hold firm or will it then choose to reassess “the efficacy and costs of such purchases”?
- In a related point, while everyone breathed a sigh of relief when the markets held up relatively well after the Fed’s most recent tapering announcement, this was still an easy test to pass. That’s because the U.S. federal government deficit has recently shrunk from $1 trillion to $500 billion, which means that there is now less new government debt for the Fed to buy. The real test will come when the Fed tapers to the point where investors need to absorb a significantly larger share of the newly issued government debt. That development should put upward pressure on bond yields and will therefore provide a truer test of the Fed’s tapering convictions.
- The Fed seems to be discounting the severe effects that tapering is having on emerging markets as the ‘hot money’ that was created by its ultra-loose monetary policies surges towards the exits in those countries. With the global economy more interconnected than ever, if the taper creates unduly adverse impacts in emerging market economies, the reverberations should eventually wash up on American shores, either directly or indirectly.
Five-year GoC bond yields fell by three basis points last week, closing at 1.57% on Friday, and lenders continue to drop their fixed rates in response. Borrowers who are putting down at least 20% on the purchase of a new home should be able to find a five-year fixed rate in the 3.29% range and borrowers who are putting down less than 20% can find five-year fixed rates for as low as 3.09%.
Five-year variable-rate mortgages are offered at rates as low as prime minus 0.65%, which works out to 2.35% using today’s prime rate of 3.00%. Variable-rate borrowers are well advised to use the interest savings offered by today’s ultra-low rates to pay off their mortgage balance more quickly. One easy way do this is to make your regular mortgage payment equivalent to today’s five-year fixed-rate payment. (Here is a recent post that shows how doing this will help protect you against future rate increases.)
The Bottom Line: The Fed’s decision to continue tapering its QE programs gives a vote of confidence to the current state of the U.S. economic recovery. While this is an encouraging short-term signal, I still think it will be some time yet before this recovery gathers enough momentum to put upward pressure on our variable mortgage rates. On the other hand, fixed rates will be more sensitive to changes at the margin as bond yields react to each new economic data release.