Why the U.S. Federal Reserve’s Rate Hike Might Push Canadian Fixed Mortgage Rates Higher

Last Wednesday the U.S. Federal Reserve voted unanimously to raise its policy rate for the first time in nearly a decade. The reaction in financial markets to this widely anticipated move was initially positive, but the euphoria didn’t last long as investors recalibrated their portfolios to account for tighter U.S. monetary policy and the resulting further appreciation of the world’s reserve currency.

Here are the highlights from the Fed’s accompanying press release:

• U.S. economic activity has been expanding at a “moderate pace”, household spending and business fixed investment have been “solid”, and the housing sector has “improved further”. The Fed expressed increased confidence in a broad range of indicators.
• The Fed observed that the U.S. labour market has shown both “further improvement” and “considerable improvement”, and the “underutilization of labour resources has diminished appreciably since the start of the year”. In my memory, these are Fed’s most favourable observations about the state of the U.S. labour market since the start of the Great Recession.
• Inflation continues to run below the Fed’s 2% target and “long-term inflation expectations have edged down”. The overall tone of the Fed’s statement gave me the impression that it would be turning its primary focus away from labour market conditions and back towards inflation when determining the timing and trajectory of its future policy-rate increases.
• The U.S. economy is likely to require “only gradual increases” in the Fed’s policy rate and the Fed expects that it “will remain below levels that are expected to prevail in the long run” for “some time” yet. Interestingly, the Fed did not make any changes to its accompanying dot plot projections, which chart where each Fed member thinks the federal funds rate will be headed in the coming years. So this initial rate rise does not appear to signal a material change in any Fed member’s longer-term view.
• The Fed will continue to provide liquidity to financial markets by “reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities … [and by] rolling over maturing Treasury securities at auction … until normalization of the level of the federal funds rate is well under way.” This was a reassurance to investors that the Fed will not start removing liquidity from the market for a long time yet.

So what are the implications for Canadian mortgage borrowers? We can’t yet know for certain but the Fed’s move does create some new risk.

If the Fed’s policy rate causes U.S. bond yields to rise, as is expected, our equivalent Government of Canada (GoC) bond yields could well get taken along for the ride. In fact, there has been an almost 100% correlation between changes in U.S. and Canadian bond yields since the start of the Great Recession. If our GoC bond yields rise, our fixed mortgage rates, which are priced on them, will move higher as well.

While there is a good argument that U.S. and Canadian bond yields will decouple, given the divergence in our respective outlooks, their correlation is well entrenched and it’s not a given that this decoupling will happen. I think Bank of Canada (BoC) Governor Poloz was actually trying to encourage the market to think about decoupling when he chose to talk about negative interest rates and his willingness to use unconventional monetary policy just prior to the Fed’s first policy-rate increase. It certainly put the BoC’s current thinking in sharp contrast to the Fed’s evolving view.

The other risk we now face is that the U.S./Canadian exchange rate will widen further. The BoC has supported a weaker Loonie for some time because it views a recovery of our export-manufacturing sector as being a key ingredient in any sustainable Canadian economic recovery. The BoC’s hope is that a cheaper Loonie will fuel export growth which will then lead to increased business investment, starting a cycle where growth fuels investment and vice versa. But there is another risk if our exchange-rate gap grows too wide. For example, a cheaper Loonie increases the cost of our imports, and many of our export manufactures need to import the manufacturing equipment or goods that are used in their manufacturing processes. When the Loonie drops in value, higher import costs must be borne right away, while the benefits of more competitively priced exports will take longer to accrue. The wider the exchange-rate gap becomes, the more short-term pain our manufacturers have to endure before they can eventually benefit from any associated gains (and that assumes they stay in business long enough to see those gains).

Five-year GoC bond yields rose by one basis point last week, closing at 0.75% on Friday. Five-year fixed-rate mortgages are available in the 2.59% to 2.74% range, but several major banks raised their five-year rates to 2.94% last week and other lenders may follow shortly. That said, five-year fixed pre-approval rates are still being offered at rates as low as 2.79% (for now).

Five-year variable-rate mortgages are available in the prime minus 0.50% to prime minus 0.35% range, which translates into rates of 2.20% to 2.35% using today’s prime rate of 2.70%.

The Bottom Line:  The U.S. Fed’s policy-rate increase creates the risk that our fixed mortgage rates might rise in the near future if the high correlation between U.S. and Canadian bond yields is sustained. Meanwhile, our variable rates, which are priced on the BoC’s overnight rate, aren’t likely to be affected because the BoC’s current assessment of our economy is far less optimistic than the Fed’s at the present time.

I will be off next week for some family time but will hit the ground running again on January 4. In the meantime, I wish you all a safe and happy holiday season. See you in 2016 …