Dave Larock in Monday Interest Rate Update, Mortgages and Finances, Home Buying
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Happy New Year and welcome back!
In today’s post we’ll kick off 2015 by looking at five key factors that will signficantly influence the direction of Canadian fixed and variable mortgage rates in the coming year.
1. The Strength of the U.S. Recovery
The U.S. economic recovery has recently shown many encouraging signs. Employment is picking up, consumer and business confidence levels are improving, and not surprisingly, spending and investment are on the rise. U.S. GDP growth for the third quarter of 2014 was recently revised upward to a whopping 5%, marking its highest level in eleven years. While fourth quarter GDP growth is expected to fall back to the 2.5% to 3% range, this will still be considered healthy by today’s developed world standards.
The continued improvement in U.S. economic momentum has fuelled speculation that U.S. Fed Chair Janet Yellen will raise the Fed’s policy rate more quickly than had previously been expected, with forecasters now calling for the first Fed raise as early as the spring of 2015. While Bank of Canada (BoC) Governor Poloz has repeatedly said that the BoC will lag the Fed’s tightening timetable, our monetary policies are closely linked, and if the Fed raises in early 2015, I expect bond-market investors to accelerate their forecasts for Canadian rate rises as well.
If this happens, the most immediate impact would be an increase in Government of Canada (GoC) bond yields, which could push fixed mortgage rates higher, while variable rates would remain at today’s levels until the BoC actually raises its overnight rate.
2. Slowing Growth in China
China’s GDP growth slowed to 7.3% in the third quarter of 2014. While that growth rate appears healthy at first glance, China has averaged 9.1% GDP growth per quarter over the past fifteen years. This slowing trend has been in evidence for some time. Consider that China’s quarterly growth rate has averaged 7.55% since the start of 2013.
The challenge for China is that about half of its GDP growth since 2000 has come from massive investment in infrastructure and factories, and that much of that money has been inefficiently spent or wasted - either on investments that are not providing meaningful returns or on projects that have been abandoned before completion. A recent study by two Chinese economists determined that prior to 1997, China needed $2.60 in investment to generate $1 of GDP growth while today that figure has risen to $4. So while China’s recent investment spending has helped its GDP growth over the short term, its ill use has not produced the lasting benefits that are needed to support robust future GDP growth.
Much of the money used to fund these investments has come from China’s unregulated shadow-banking sector, which has ballooned to alarming levels. China’s regulators are now trying to reign in further shadow banking growth because it is viewed as a significant systemic risk. If this type of lending dries up, so too will the investment projects that have been financed with these loans.
China’s policy makers recognize the need to retool its growth model from one based on investment-led growth to one more focused on consumption-led growth. But this is easier said than done for such a large and complex economy, and there will be many growing pains along the way.
From a Canadian perspective, China has been the world’s marginal buyer of most commodities for some time now, which means that incremental changes in Chinese demand have determined their price. If the growth rate China’s economy continues to slow, its demand for commodities will wane and their prices may fall. Given that commodities account for a large percentage of Canadian exports, a Chinese slowdown could have a significant negative impact on our overall economic growth. While this would certainly not be good news for Canadians, the knock on effects to our economic momentum would put downward pressure on our mortgage rates.
3. The Continuation of Large-Scale Quantitative Easing (QE) Programs
The U.S. Fed unwound its QE programs in 2014 but global financial markets are still awash in liquidity. In the same week that the Fed wrapped up QE3, Japan announced the most radical form of QE yet on record. Meanwhile China may well have to resort to its own version of QE to staunch its flagging economic momentum and European Central Bank (ECB) Governor Mario Draghi continues to hint that the euro zone will embark on its own version of QE if necessary. I think it is inevitable that sooner or later international bond-market investors will call his bluff. At the moment, there is no sign that this is about to happen and until then, global markets will remain flooded with liquidity for about as far as the eye can see.
From a Canadian perspective, when global financial markets are flooded with liquidity, bond yields fall almost everywhere. Since QE is invoked to counteract economic weakness, bonds from developed countries like Canada, which have not engaged in any QE since the start of the Great Recession, enjoy a ‘quality’ premium that drives their yields lower still. I expect these QE-type monetary policies to exert downward pressure on our bond yields, and by association, our fixed mortgage rates, for as long as they continue.
4. The Price of Oil
In Canada, sharply falling oil prices produce both winners and losers. Cheaper oil leads to a drop in gas prices that puts extra money in consumer wallets, and this has the same impact as an across-the-board tax cut. If consumers spend this extra saving in other areas, as most average Canadians will, cheaper oil prices provide our economy with a broad form of economic stimulus. Falling oil prices also make operating costs cheaper for businesses (some more than others), and put downward pressure on the Loonie, making our exports more competitive and providing a boost to our weak but slowly recovering manufacturing sector, which is most heavily concentrated in Ontario and Quebec.
Conversely, when oil prices fall, as they have, by roughly half over a short period, oil rich Alberta suffers badly and Alberta has been a major engine of growth for the Canadian economy. Oil companies cut back on exploration and development, and a diverse range of businesses supporting the oil-patch experience a sharp drop in demand for their products and services.
At the national level, energy is our largest export, accounting for a little less than a quarter of our total. Since the start of the Great Recession, Alberta’s oil patch has created the lion’s share of new, high-paying jobs, so a drop in oil prices wipes out what has been the main driver of Canadian job growth over the past several years. (The same is true in the U.S., where the shale oil boom has been a key driver of growth and has provided the majority of new, higher-paying jobs since the start of the Great Recession.)
The BoC has already noted its concern about the impact of sharply lower oil prices on our economy, and this development is likely to make the Bank more cautious when determining the timing of future overnight rate increases (on which our variable mortgage rates are priced). On balance, the most immediate impacts of lower oil prices are likely to be negative, creating a headwind for our economic momentum and exerting downward pressure on GoC bond yields and our fixed mortgage rates. It is also true that cheaper oil will help keep the value of the Loonie lower, and make our exports more competitive, but this benefit will take longer to accrue.
5. The Potential for the Next Financial Crisis
The global economy survived 2014 without experiencing any major financial crises but that isn’t because the risks weren’t there.
Japan’s moribund economy saw a rare and brief surge after the Bank of Japan ramped up its QE programs and publicly stated its desire for 2% inflation, but since then the country has slipped back into recession. Japan’s debt levels are staggering. The experts I read believe that the country has long passed the point where some form of debt default must eventually occur.
The euro zone isn’t officially in recession but that is only by the skin of its proverbial teeth, with its GDP growth rate averaging a little more than 0.2% over the most recent four quarters. The region depends on Germany as its main economic driver and that country only barely pulled out of recession in the third quarter of 2014, with GDP growth estimated at 0.1%. The euro zone has lurched between recession and miniscule growth for years now, and it still cannot agree on the appropriate monetary and fiscal policies to counteract this weakness. So far, bold words from ECB President Draghi have soothed the occasional bond-market flare-up, but we haven’t seen the kind of meaningful reforms that it will take to better steer the region through its next major crisis, which seems inevitable to many.
China may be in the midst of the biggest property bubble in modern history. Sharply falling oil prices have devastated Russia, where inflation is now rampant, as well as Iran and Venezuela, and put economic pressure on other OPEC countiries including even Saudi Arabia. Argentina’s government defaulted on its debts for the eighth time this past summer and many believe that other countries, such as Greece, may not be far behind.
The global economy is more interlinked than ever, so any and all of these systemic risks have the potential to send shock waves around the world, creating a domino effect that could destabilize other weak economies, particularly the developing economies that have been the main source of recent global growth.
From a Canadian perspective, instability elsewhere has increased demand for GoC bonds, as investors worry less about the return on their capital and more about the return of their capital. If past is prologue, that means that GoC bond yields, and by association, our fixed-mortgage rates, should fall if fears of another financial crisis become elevated. (Of course, if a full-blown crisis ensues, there is the potential that bond yields everywhere could rise, but this still appears to be a low-probability event, at least from my desk.)
Most of the projections for 2015 that I have read paint an optimistic view for the global economy in the year ahead, continuing a pattern of forecasting we have seen since the start of the Great Recession. Thus far, those forecasts have consistently overshot. While it is true that we can now point to more encouraging signs of recovery than in recent years past, we should be careful not to overweight improvements in the shorter-term data when the global economy must still overcome the wide range of significant longer-term challenges that I have outlined here.
Five-year GoC bond yields have fallen by five basis points since my last update on December 22, closing at 1.32% last Friday. Five-year fixed-rate mortgages remain in the 2.79% to 2.89% range, while five-year fixed-rate pre-approvals are offered at 2.99%.
The Bottom Line: My crystal ball for forecasting where mortgage rates are headed is as murky as ever but for the reasons listed above, I believe that most of the key drivers will continue to exert downward pressure on our fixed-mortgage rates in the year to come and will keep our variable rates at or near today’s ultra-low levels for the foreseeable future. It will be important to stay tuned, however, because a major cirisis of any kind could change that situation quickly.
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, Move Smartly, and on his own blog: integratedmortgageplanners.com/blog Email Dave
