Why I Think the Recent Bond-Yield Spike is Full of Sound and Fury, Signifying NothingJanuary 7, 2013
Why Chinese Growth is Good for Canadian Variable-rate Mortgage HoldersJanuary 21, 2013
Japan Steps Up the Currency Wars
Japan recently adopted a much more aggressive policy of ‘Beggar Thy Neighbour’ currency devaluation. Newly elected Prime Minister Shinzo Abe wants to weaken the yen to make Japanese exports more competitive in an attempt to boost his country’s growth prospects. Japan has suffered from stagnant growth for decades so this populist approach sold well during election season. But currency devaluations are a zero sum game, meaning that the only way Japan can gain momentum using this approach will effectively be to steal growth from other countries.
Japan’s trading partners know full well what’s at stake and they have responded in kind to protect their own economic momentum. In recent months as Japan’s attempts at currency devaluations have become increasingly more aggressive, countries as diverse as the Czech Republic, Turkey, South Korea, Taiwan, Peru and Brazil have all responded by, for example, lowering their central bank policy rates, intervening in domestic bond markets, taxing foreign capital inflows and purchasing foreign currencies with central bank reserves. History has shown that currency wars create a race to the bottom which offers participants only fleeting, short-term benefits and can trigger hyper-inflation, deflation or even both – one after the other, as bi-products. Currency war advocates should be careful what they wish for.
In fairness to Japan, there are other countries that have also pinned their recent recovery hopes on a cheaper currency and Japan’s leaders would argue that it actually joined this current currency war late. That’s certainly true when compared to the actions of Ben Bernanke and the U.S. Federal Reserve. On that note, I expect Japan’s aggressive currency interventions to trigger more quantitative easing by the U.S. Fed, which recently gave itself an open mandate to do just that.
(Side note: Canada benefited greatly from currency devaluation during the mid-1990s when our federal government embarked on spending cuts and tax increases to overhaul its unwieldy budget and bloated balance sheet. The key difference back then we that we were a small, open economy which was struggling while most of the world’s larger economies (particularly the U.S.) were rolling along. While we had to endure jokes about the Loonie being called the ‘Northern Peso’, our relatively cheaper Loonie did not cost our much larger trading partners enough to trigger a currency war and the cheaper Loonie went a long way toward speeding our recovery. We were lucky in our timing.)
The Lofty Loonie and the Greenback
The Loonie continues to trade at or above par with the Greenback and this has made our exports less competitive in a market that buys about 80 percent of what we sell outside of our borders. The lofty Loonie has created a powerful headwind that acts against our economic momentum (particularly in the heavily manufacturing-based provinces of Ontario and Quebec).
If this trend continues , as it has already done for some time now, the gap between our actual economic output and our potential economic output will widen in the export-oriented sectors of our economy. In this way, a higher Loonie will produce much of the same disinflationary impact that Bank of Canada (BoC) rate increases would otherwise, and for that reason, the continued strength of the Loonie makes it far less likely that the BoC would increase its overnight rate (on which all other Canadian interest rates are either directly or indirectly based). Thus, what’s bad for export-oriented manufacturing companies in central Canada is good for anyone hoping that mortgage rates will stay low.
It follows that the key currency question for Canadian mortgage borrowers is: How long will the Loonie trade at or above par with the Greenback?
While the answer to that question has historically centred around how the Loonie moves in conjunction with commodity prices, that well-established relationship no longer tells the whole story.
Here are three other factors that explain why the Loonie is trading above par againt the Greenback today:
- In normal times the U.S. Fed’s balance sheet is about 12.5 times the size of the BoC’s balance sheet, which is roughly consistent with the difference in our population sizes. Compare that to today, when the U.S. Fed’s balance sheet is now 40 times the size of the BoC’s balance sheet and you can start to understand why investors are showing more confidence in Canada. This gap should continue to widen as all signs point to further aggressive balance-sheet expansion by the U.S. Fed. (For the latest example, see the currency war discussion above.)
- On a related note, there are usually ten times more Greenbacks than Loonies in circulation but today that ratio has more than doubled as the U.S. Fed has kept its printing presses running around the clock while the BoC has maintained a much more conservative approach. (No currency wars north of the 49th parallel.)
- This may come as a surprise in light of the points listed above, but investors who want to park their money in short-term government debt can earn 0.90% more yield by buying short-term Government of Canada (GoC) bonds versus their U.S. equivalents. The U.S. Fed has made it clear that it doesn’t plan to raise its policy rate any time soon, so any further BoC increases to its overnight rate would widen this gap and drive the Loonie higher still.
After reading all of the above, does it come as a surprise that American investors have funneled more than $300 billion into Canadian portfolio securities since Ben Bernanke and the U.S. Fed began their quantitative easing programs in 2009?
Five-year GoC bonds yields were one basis point higher for the week, closing at 1.48% on Friday. Lenders continued to raise their five-year fixed-mortgage rates and while sub-3% rates are still on offer, they are now much less widely available.
Five-year variable-rate mortgages are still priced as low as prime minus 0.40%. Using today’s prime rate of 3.00%, that works out to 2.60%, or approximately 0.35% below today’s equivalent fixed rate. Despite this relatively narrow gap, if you subscribe to my evolving view that we are probably headed for an extended period of ultra-low interest rates, then today’s best variable rates still present a compelling option.
The bottom line: For the reasons outlined above, I believe that the Loonie will stay at or above par with the Greenback for the foreseeable future. If I’m right, this will greatly reduce the chance of any material increase in the BoC’s overnight rate at least until the U.S. Federal reserve raises its policy rate in 2015, or beyond.