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When the minutes from the Fed’s latest Federal Open Market Committee (FOMC) meeting were released last week, investors saw what they wanted to see.
While the Fed is clearly determined to reduce the $85 billion of U.S. treasuries and mortgage-backed securities it buys each month, its FOMC members remain cautious about the timing of this withdrawal.
The Fed has good reason for wanting to taper. Most importantly because its latest quantitative easing (QE) programs do not appear to have created much positive impact on U.S. economic growth. Several of the economists I read regularly have long predicted that QE3 would only push ultra-low interest rates a little lower, and as such, could only have a marginally positive economic impact. Meanwhile, QE3 has distorted market fundamentals, has undermined the world’s faith in the U.S. dollar as the globe’s reserve currency, and has heightened fears that the Fed’s bloated and expanding balance sheet is a ticking time bomb that will destroy the prospects of America’s future generations.
But now that the Fed has put itself in this mess, withdrawing $85 billion in monthly demand from the U.S. bond market is easier said than done. For starters, that’s a lot of cheese (I think this graphic does a good job of putting things in perspective). The U.S. Fed now buys approximately 75% of all the new securities issued by the U.S. treasury department. If the whole point of QE3 was to suppress medium-term interest rates, what will happen to those rates when the Fed stops being the marginal buyer of U.S. treasuries?
So far the Fed’s tapering plans have only been a talking point, and bond yields have already surged higher. Once the Fed actually reduces its treasury purchases, how much higher will yields have to rise before there is enough open-market demand to offset the enormous void that will be created by the Fed’s withdrawal? Like many other observers, I think the volatility that will accompany this process of “price discovery” has the potential to undo most, if not all, of the limited positive economic momentum that QE3 created.
To be clear, I don’t think the Fed is tapering QE3 because its objectives have been met - as it claims. Instead, I think the Fed is trying to beat a hasty retreat because a) the cost of QE3 has far outweighed its benefits and b) the Fed has always known that it could not continue to overpower market forces indefinitely.
Here are some additional thoughts on the all-consuming topic of the Fed’s tapering plans:
- The U.S. treasury department will issue fewer securities over the balance of 2013, primarily because the U.S. federal government’s deficit is shrinking. This means that the Fed will be able to reduce, or taper, the amount of U.S. treasuries it buys while still buying the same proportion (75%) of the treasury’s new issues. In other words, the Fed will be able to buy less while leaving the current supply/demand balance for new treasuries unchanged.
- By the middle of next year, the U.S. Fed will have a new chairperson and may have as many as seven new FOMC members (out of twelve in total). This significant turnover in personnel will happen while the Fed is in the midst of trying to unwind the largest QE program in U.S. history. Financial markets perform best when the Fed’s actions are stable and predictable. Today we don’t even know the names of most of the people who will be managing the Fed through this tapering process.
- The Fed has insisted that it will taper only if U.S. economic data continue to strengthen. Meanwhile, the U.S. treasury has already hit its latest $16.7 debt ceiling and is now funding itself with emergency cash reserves that should only last until October or early November. If Congress pushes the treasury to the brink of default, as it did the last time the debt ceiling limit had to be raised, this will create a powerful headwind for U.S. (and global) economic momentum. At this point, another round of brinkmanship appears highly probable.
- U.S. new home sales declined by 13.4% in July, marking the biggest decline in new home sales since May of 2010. This seems to indicate that higher interest rates are having an immediate impact on the U.S. housing recovery. And the Fed has said it will look to that recovery as a key barometer when determining the timing and extent of its tapering plans. When tapering actually starts, yields can be expected to rise higher still, and this will further undermine the U.S housing recovery. (I wrote in detail about the self-reinforcing conundrum that is inherent in tapering last week.)
Interestingly, while the Fed has tried to use staggering levels of QE in an effort to suppress interest rates, research shows that the Fed is actually much more effective at influencing interest rates when it simply offers forward guidance on when it is likely to increase its short-term policy rate. And this latter strategy costs the Fed nothing. Because of that, when the Fed announces that it has begun to taper, I expect that it will also extend its guidance on the timing of future short-term rate increases as an offset, in the hope that this will keep bond yields at least partially anchored.
If you’re a Canadian variable-rate mortgage borrower, that announcement will be welcome news. As I have written in many a Monday Morning Update, the Bank of Canada (BoC) isn’t likely to raise its overnight rate, on which our variable-rate mortgages are based, until the Fed increases its comparable short-term policy rate. This is because our economies, and our monetary policies, are tightly linked. As such, if the BoC were to raise before the Fed and cause the gap between Canadian and U.S. short-term rates to widen further, the Loonie would appreciate against the Greenback and heap further suffering on our already beleaguered and vulnerable exporters.
Conversely, if you are in the market for a five-year fixed-rate mortgage, which moves in conjunction with the Government of Canada (GoC) five-year bond yield, then the results of the interplay between the Fed’s decision to begin tapering and its attempt to anchor medium-term rates by extending its forward guidance will be less certain. Given that, I expect the ride for prospective five-year fixed-rate borrowers to be much bumpier.
Five-year GoC bond yields were two basis points lower for the week, closing at 1.94% on Friday. Despite this small decrease, the Royal Bank of Canada led fixed-mortgage rates higher by raising rates across the board. Five-year fixed rates are now offered in the 3.50% range and ten-year fixed rates are now only available at rates above 4.00%.
Five-year variable rates are still offered in the prime minus 0.55% range (which works out to 2.45% using today’s prime rate), and this option grows increasingly more appealing as the gap between five-year fixed and variable rates continues to widen. That said, variable-rate borrowers will find it a little harder to qualify for a mortgage after this Wednesday because the BoC’s qualifying rate, which is used to underwrite variable-rate applications, will also rise. As a reminder, the BoC calculates the qualifying rate by taking an average of the posted five-year fixed rates at Canada’s largest six banks.
The Bottom Line: Financial markets continue to react to every new hint about when the U.S. Fed will start to taper its QE programs. While that volatility has once again pushed our fixed-mortgage rates higher, it also bolsters my belief that variable-rates should remain at current levels well into the future.
David Larock is an independent mortgage planner and industry insider specializing in helping clients purchase, refinance or renew their mortgages. David's posts appear weekly on this blog (movesmartly.com) and on his own blog integratedmortgageplanners.com/blog). Email Dave