What the U.S. Fed’s Surprising Shift in Tone Means for Canadian Mortgage RatesMarch 21, 2016
Why Markets Aren’t Likely To Overreact To the Latest U.S. Employment DataApril 4, 2016
Canadian mortgage borrowers have enjoyed rock-bottom fixed and variable mortgage rates for years, and that isn’t likely to change soon. Our economy is mired in a low-growth, low-inflation environment and higher rates aren’t near the top of our policy makers’ worry list. Instead, they’re focused on helping the cheaper Loonie fuel a manufacturing renaissance in an effort to replace our lost energy-sector momentum. And while there are encouraging signs that this transition is finally underway, it has been slow to develop. So today’s ultra-low interest rates are basically our silver lining on an otherwise cloudy economic day.
Although higher rates may not appear imminent, we shouldn’t become complacent about this extended period of super-cheap borrowing costs. Our circumstances can, and often do, change more quickly than expected. A small country like ours is vulnerable to global forces, most especially to the gyrations of the economic giant to our south. Our bond yields have changed in lockstep with U.S. yields for years now, so like it or not, if U.S. rates head higher, it’s a good bet that we’re going to be taken along for the ride (at least initially).
To that end, in today’s post we’ll look at three developing U.S. trends which have the potential to both push our mortgage rates higher, and to do so more quickly than expected.
Trend #1: The Improving U.S. Labour Market
The U.S. Federal Reserve’s monetary-policy has been designed to help the U.S. labour market since the start of the Great Recession (there are lots of smart people who say that the Fed’s efforts have hurt more than helped but that is a topic for another post). The Fed repeatedly set unemployment rate targets that it said it would use to determine whether and when monetary-policy adjustments would be made. Then later, when the unemployment rate reached those targets, the Fed repeatedly decided not to adjust monetary policy after all. Its rationale was that the improvement in the U.S. unemployment rate was caused by short-term technical factors, and was therefore not a signal that a lasting, healthy labour-market recovery was underway (as the Fed had hoped and expected).
Each time the Fed moved the goal posts to avoid tightening monetary policy it lost some credibility, and recognizing this, it eventually stopped using the headline unemployment rate as its target. Instead it chose to rely on a more sophisticated scorecard that incorporates several labour-market measures and data points. This gave the Fed more leeway because it allowed for a more subjective interpretation of the data but this change, combined with the Fed’s lack of follow through on its previous targets, also made financial markets more complacent about incremental changes in U.S. labour market conditions.
Fast forward to today. The U.S. unemployment rate is a drum tight 4.9% and the U.S. economy has created an average of 225,000 new jobs per month over the past twelve months. Despite this, instead of adjusting rate expectations, many market watchers have discounted U.S. job-growth improvements, using two key qualifiers: 1) The surge in U.S. job growth has not corresponded with a rise in average incomes, and 2) The U.S. participation rate, which measures the percentage of working-age Americans who are either employed or are actively looking for work, still sits near record-low levels.
Both of these well-established views are now being challenged.
For starters, average incomes have historically proven to be a lagging indicator and as such, if the Fed waits for evidence of strong income growth, it may then need to tighten its monetary policy more quickly than planned to keep labour costs under control. Furthermore, average U.S. income growth isn’t as bad as many people think. Economist David Rosenberg recently noted that average U.S. personal incomes rose by more than 3% in 2015 and average wages grew by 4% over the same period, so this lagging indicator isn’t exactly lagging anymore.
While it’s true that the U.S. participation rate still hovers well below average historical levels, there is growing acknowledgment that this is largely due to demographic changes in the workforce. Specifically, baby boomers retiring in record numbers each year. If that’s true, then the low U.S. participation rate is being caused by structural factors that the Fed’s monetary policy can’t, and shouldn’t try to, counteract (because you can’t use monetary policy to stop your workforce from aging).
On a related note, if those higher-earning baby boomers are retiring and being replaced by lower-earning new entrants, this would naturally exert downward pressures on average incomes. If incomes still managed to rise by 3% in 2015 despite this powerful demographic headwind, could it be that the U.S. labour market is much healthier than is widely believed? And if/when market watchers come to that realization, we could see a sharp adjustment in U.S. treasury yields as investors recalibrate their inflation.
Trend #2: Rising U.S. Inflation
Overall U.S. inflation, as measured by the Consumer Price Index (CPI), has been below the Fed’s target almost every single month for the past five years. This has given the Fed some additional leeway to keep its monetary policy at ultra-accommodative levels while the labour market continued to heal. But there are signs that U.S. inflation pressures are rising, and that could force the Fed’s hand.
This is happening in part because some of the tailwinds that have helped push prices down are abating. For example, the value of the U.S. dollar surged because markets believed that the Fed was about to repeatedly raise its policy rate at a time when other central banks were either cutting rates and/or speculating about resorting to negative interest rates. The stronger U.S. dollar lowered the price of imports throughout that period, but now that the Fed has adopted a more dovish monetary-policy tone, the dollar has weakened, and this has caused the prices of imports to rise instead. So the changes in the value of the US dollar have reversed their impact on the U.S. economy – where they were once deflationary, they are now inflationary.
The steady plunge in energy prices was another tailwind. It lowered energy costs for American consumers and provided a net benefit to the U.S. economy. But the price of oil stopped falling and then rebounded in February. Since inflation growth measures incremental changes in prices, if this latest surge in oil prices is sustained, the eighteen-month tailwind of sharply lower energy prices that ended recently will be replaced with a headwind of gradually rising energy costs.
U.S. labour was also relatively cheap for an extended period. But now that average U.S. incomes have been outpacing overall inflation over the last twelve months, labour-cost pressures are also rising.
The Fed will probably tolerate above-target inflation for a period of time, but if prices continue to rise, the Fed may have to tighten more quickly than expected. If that happens, U.S. treasury yields could spike as the consensus recalibrates its inflation expectations.
Trend #3: Waning Foreign Demand for U.S Treasuries
China is the U.S.’s biggest creditor and the Chinese government has been dumping its U.S. debt holdings for some time now. It is estimated that China reduced its holdings by $187 billion in the first ten months of 2015. And it’s not just China. Foreign governments as a whole sold more U.S. treasuries than they bought in eleven out of twelve months in 2015, unloading a net total of $225 billion in U.S. debt over that period – and this is happening as the US issues more and more debt to cover its ongoing deficits.
Many of these countries are selling their U.S. debt in order to prop up their currencies or to free up cash to bolster their own economies. But whatever their reasons, the international demand for U.S. treasuries is waning. U.S. analyst Stephanie Pomboy estimates that there is now a gap of about $800 billion between the $1.1 trillion that the U.S. treasury must borrow to cover its budget gap and the roughly $300 billion that foreign investors are buying. There are few signs that U.S. banks, corporations and households are stepping in to fill that gap. Unless someone does, the Fed will have two choices:
- Allow U.S. treasury yields to rise to a level that will attract the necessary demand. Given the size of the funding gap, it is unlikely that the Fed would allow yields to rise to the required level, because the resulting spike in rates would risk derailing all of their recovery efforts.
- Monetize the debt. In this scenario, the Fed would print money and buy the amount of treasuries required to keep their yields at manageable levels. While this might provide a short-term fix, debt monetization by the world’s largest economy would represent a dangerous experiment, could well lead to significantly higher inflation, and worse still, might irreparably undermine the world’s faith in the Greenback as its reserve currency (please remind me to buy a lot of gold if this happens).
Lastly, and this isn’t just me trying to be funny, if Donald Trump becomes the Republican nominee we may see foreign investors dump their U.S. debt in a scramble to reduce their exposure to a country that might be electing a guy whose only clearly articulated policies involve building walls along the Mexican and Canadian borders. (Of course, if Trump wins we might need a wall to prevent a sea of American moderates from trying to flee north.)
Five-year Government of Canada bond yields rose by two basis points last week, closing at 0.73% on Friday. Five-year fixed-rate mortgages are available in the 2.39% to 2.59% range, depending on the terms and conditions that are important to you, and five-year fixed-rate pre-approvals are offered at rates as low as 2.69%.
Five-year variable-rate mortgages are available in the prime minus 0.30% to prime minus 0.40% range, which translates into rates of 2.40% to 2.30% using today’s prime rate of 2.70%.
The Bottom Line: The three U.S. trends outlined above have the potential to both push U.S. treasury yields higher and to force the Fed to raise its policy rate more quickly than the markets now expect. To be clear, I don’t see these trends as near-term risks, but rather as unfolding developments to be monitored. Forewarned is forearmed.