The Distant Risk of Higher Mortgage RatesFebruary 19, 2013
What Slower GDP Growth Means for Mortgage RatesMarch 4, 2013
The latest U.S. and Canadian CPI data bolster my belief that the Bank of Canada (BoC) is more likely to lower, rather than raise, its overnight rate as its next move to maintain its medium-term inflation target of 2%.
That said, while I continue to believe that inflation will remain benign for the foreseeable future, eventually, inevitably, it will rise in accordance with the intentions of the U.S. Fed (more on that in a minute).
First, let’s look at how large deficits and high levels of government debt have impacted our mortgage rates to date.
Much of the developed world is now mired in a mutually reinforcing cycle where high government debt and deficits act as a drag on growth, which lowers business and consumer confidence and with it, consumer demand. Low demand causes disinflation and in such an environment, central banks lower their policy rates to ward off the threat of deflation. They do this primarily to stimulate spending and investment but also to lower the interest cost of financing their governments’ deficits. If policy rates reach 0%, central banks like the U.S. Federal Reserve then resort to unconventional methods, like quantitative easing, to inject further liquidity into their economies. This allows all debt levels to increase still further. It’s like a drug dose to an addict – it helps in the short term but just makes the long term more difficult.
At a very basic level, bloated government debt and deficit levels have fueled today’s low-interest-rate environment. Here’s how this feedback loop works:
- The incremental increases in today’s high government (and consumer) debt levels are being used largely to finance current consumption, soaking up an increasing share of resources that might otherwise be directed toward investment and productivity improvements. (BoC Governor Mark Carney has been imploring our businesses to use today’s ultra-low borrowing rates to do just that since the start of the Great Recession, to only limited effect because businesses are rightly concerned about the future.) While there is some debate about the size of the difference, economists agree that private-sector spending produces a much greater multiplier effect for the economy than government spending. (The “multiplier effect” is the extent to which each dollar spent has an impact of greater than one dollar on the overall economy.) So when government spending replaces private spending, the economy suffers.
- As government debt increases, it raises the prospect that higher taxes on the private-sector will be required to service it, dramatically so when interest rates rise and raise government borrowing costs as they must ultimately do. The spectre of higher taxes (or worse, financial crisis) is further exacerbated today in countries with aging populations and underfunded entitlement programs. The governments in these countries have little remaining flexibility to address their budget gaps and the experts I read estimate that each 1% increase in a country’s marginal tax rates will reduce its real GDP by 2 to 3% over the subsequent three years. Thus it is no surprise that business and consumer uncertainty continues to rise alongside government debt levels. It’s this lack of confidence and the consequent reduced circulation of money that explains why the Federal Reserve’s increases to the U.S. money supply have not produced the expected improvements in U.S. economic activity.
- As business and consumer confidence falls, discretionary spending and non-essential investment is postponed, lowering overall demand. This reduced demand causes the rate of inflation to fall (a process known as disinflation). Disinflation and ultra-low short-term interest rates then put downward pressure on medium- and long-term bond yields. On such a sea are we now afloat.
The current ultra-low interest-rate cycle in the U.S. and Canada will eventually end in one of three ways:
- Western governments resort to harsh austerity measures to bring budgets back into line with expenditures. (Highly unlikely for reasons of political survival.)
- Bond-market investors lose confidence in governments’ ability to repay their debts and bond yields spike to unsustainable levels, forcing one or more sovereign defaults. Once sovereign default occurs, bond-market investors get nervous and demand higher yields for all government debt. (Unlikely, but still possible in at least a few euro-zone countries.)
- Stronger economic growth causes the U.S. Federal Reserve’s newly printed trillions of dollars to start circulating in the U.S. economy, triggering higher levels of inflation and lowering the ‘real’ value of outstanding U.S. federal government debt. Although this inevitably results in higher interest rates that cost more to service, the deflating real value of the debt means that there is less of it to pay off in real terms. The lender gets his dollar back but never recovers the real purchasing power of the dollar that was originally lent. This is viewed as the most politically expedient outcome and examples abound throughout history. In the words of Hayek: “History is largely a history of inflation, usually inflations engineered by governments for the gain of governments.”
Canada has a small, open economy that is highly integrated with the U.S. so we will inevitably import this U.S. inflation when it rears its head. History has taught us what will happen next, the only real question is one of timing.
Five-year Government of Canada bond yields were eight basis points lower for the week, closing at 1.40% on Friday. Any short-term upward pressure on bond yields (and therefore mortgage rates) has now been reversed as evidence of our continued economic slowing continues to mount. Five-year fixed-mortgage rates are once again widely available at sub-3% rates.
Variable-rate mortgages are attracting increased rate competition among lenders and as the prospect of a possible BoC rate cut increases, I expect borrower interest in this option to continue to increase.
The bottom line: Today’s high government debt and deficit levels have helped fuel today’s ultra-low interest-rate environment. While it will never acknowledge this publicly, the U.S. federal reserve’s long-term solution will almost certainly be to inflate its way out of the debt. When this eventually happens, we will see higher mortgage rates, but the latest CPI data tell us that this development is still a ways off on the horizon. Rest assured that I’ll be keeping my binoculars at the ready.