Dave Larock in Interest Rate Update, Mortgages and Finances
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Happy new year and welcome back.
To kick off 2017, in today’s post we’ll take a look at how the world’s largest economies are likely to impact Canadian mortgage rates in the year ahead. While it may not seem obvious at first glance, events in far off places can and do impact the rates we pay on our mortgages.
The global economy is more interconnected than ever and a small, open economy like ours is influenced by many factors beyond our borders. It is readily apparent that developments in the U.S. will have a significant impact on our economic momentum and mortgage rates in the year ahead, but so too might the next euro-zone crisis (this time involving Italian banks) or the growing pains of China as it continues to undergo its fundamental (and unprecedented) transition from an export-based manufacturing economy to one that is service-based and domestically focused instead.
Here is a look at the key factors in the world’s largest economies that mortgage borrowers should be keeping an eye on, with a brief look at the Canadian economy as well. This will serve as an outline of the themes that we will be returning to as we try to interpret and forecast mortgage-rate movements in the year ahead.
China
China is in the midst of the largest economic transition in history as it tries to reduce its reliance on export-led manufacturing and to focus instead on growing its domestic service-based sector. But this undertaking is fraught with difficulty, especially for a country that has relied so heavily on debt-financed infrastructure investment for its growth.
While reliable Chinese data can be hard to come by, we know that China’s debt has been expanding at a rapid pace for years now, we know that its steady increase in non-performing loans has repeatedly raised concerns among Chinese policy makers, and we know that while its leaders have made attempts to reign in China’s rate of debt expansion, they have quickly backtracked on these debt-limiting measures when their impacts began to bite.
There is considerable uncertainty surrounding China’s current economic transition, and changes in the country’s momentum will have significant global impacts. For example, China’s massive infrastructure investments have made it the marginal buyer of the world’s commodities, and as such, Chinese demand effectively determines today’s commodity prices. While we don’t sell a lot of commodities directly to China, changes in world commodity prices can have a major impact on our economy and that means that China’s economic momentum will affect ours, albeit indirectly.
Over the longer term, China’s transition to a domestically focused, service-based economy will require a massive expansion of the country’s middle class, and as China’s middle class becomes more educated and prosperous, it can be expected to demand more legitimate political representation. This presents a huge risk for a country whose leaders prize political stability (and their retention of power) above all else, and China’s President, Xi Jinping, has been rapidly consolidating his power base in preparation for the political turbulence that may come.
Key Themes in 2017: If China’s economic momentum slows and it buys fewer commodities, expect our economic momentum to slow along with it. While this would help keep inflation and mortgage-rate increases at bay, it won’t help Canadians afford houses, especially at today’s prices. Also, if fears over the bursting of Chinese debt and property bubbles are realized, we could see another run on safe-haven assets that would push Government of Canada (GoC) bond yields lower. On the other hand, significant economic instability in China would also be expected to trigger shocks in other countries, many of which are not well positioned to withstand them. While a less likely outcome, if a broader destabilization of the global economy results, interest rates everywhere could rise as investors begin to doubt whether sovereign debt really deserves its safe-haven status. Because of their potential to push Canadian mortgage rates in either direction, events in China bear close watching.
The Euro Zone
The euro zone continues to lurch from one crisis to the next, with the latest involving an Italian banking crisis that will require another bailout from the Troika (comprising the European Commission, European Central Bank, and International Monetary Fund). Unlike Greece, which represented a tiny proportion of total euro-zone debt, Italy’s bond market is the third largest in the world. That significantly raises the stakes in the bailout negotiations. If Italy goes down, there is little doubt that it will take the euro with it.
That said, how much appetite will German voters have for underwriting more bailouts when they go to the polls this year? And will Italians accept the oppressive and controversial austerity measures that haven’t produced the expected results elsewhere and resign themselves to a bleak economic future?
Meanwhile, the European refugee crisis continues unabated and there is rising resentment throughout European countries that are having their immigration policies dictated by Brussels (which is considered the de facto capital for both the euro zone and the European Union). Will France succumb to the same populist wave that swept Donald Trump into power and elect the right wing Marine La Pen as a repudiation of the whole euro zone experiment? Will right wing groups in the Netherlands rise to power for the same reason?
My scepticism about the future of the euro zone remains. I just don’t think that you can centralize monetary policy without centralizing fiscal policy and that means that euro-zone countries must either cede their fiscal authority to Brussels or repatriate their monetary authority. Instability will remain until this fundamental conflict is reconciled. More bailouts may buy the euro zone’s leaders more time by kicking the can down the road a little further, but the region’s day of reckoning will still arrive (eventually).
Key Themes in 2017: Thus far, euro zone flare ups have increased demand for safe haven assets and that has driven down Canadian bond yields, and by association, our fixed mortgage rates. I believe the euro zone is headed for a tough year and, if past is prologue, that will put downward pressure on our mortgage rates. [Unless, as is the case with China, the next crisis triggers broader global economic instability that leads investors to reassess the safe-haven status of sovereign debt – Canadian or otherwise.]
The U.S.
U.S. bond yields have surged higher since the U.S. election and since GoC bond yields continue to move in lockstep with their U.S. equivalents, our fixed-mortgage rates have been taken along for the ride.
At some point, the correlation between Canadian and U.S. bond yields should weaken as it becomes clearer that our economies are now progressing on significantly different trajectories (which I wrote about recently here). But it could still be a long time before that happens.
The rise to power of President-elect Trump has heightened uncertainty both in the U.S. and throughout the global economy. Bond-market investors have priced in material increases in U.S. inflation, but I believe there is some wishful thinking involved in the recent run-up in U.S. bond yields. For example, while President-elect Trump’s pledges to increase infrastructure investment and lower tax rates may improve U.S. economic momentum, the expanded federal deficit levels that these initiatives will require, and his promises of protectionist trade policies, will both act as countervailing negative influences. The recent surge in U.S. bond yields prices in all of the former and none of the latter.
Although seldom talked about, there are two more important obstacles to Trump’s plan to dramatically increase the U.S. deficit: both houses of the U.S. Congress. Although they are both controlled by the Republican party, nominally his party, their Republican representatives have a record of steadfastly opposing any measure that would increase the deficit. I believe that Trump, despite his party alignment, will encounter major resistance to, and perhaps even blockage of his plans, particularly the infrastructure spending component.
Since the Great Recession in 2008, the missing ingredient in the U.S. recovery has been business investment. If U.S. businesses weren’t confident enough to invest before the November election, it’s hard for me to believe that they are now more inclined to do so when there is so much more uncertainty (notwithstadning the recent uptick in U.S. sentiment surveys).
It’s true that the U.S. Federal Reserve is promising three policy-rate rises in 2017, but they have been over-promising on rate increases for years. If the Fed is still data dependent (which it may not be anymore), how will it assess the economic impacts of the surging U.S. dollar, when its sharp rise has already produced an anti-inflationary impact that is equivalent to significant monetary-policy tightening? And will the Fed raise rates at a time when average annual U.S. GDP and inflation growth are both below 2%, and where average U.S. incomes are barely keeping pace?
Key Themes in 2017: For the time being, further increases in U.S. bond yields will translate into higher mortgage rates for Canadian borrowers. But I think that U.S. bond market investors have overshot and if I’m right, U.S. bond yields will come back down. Also, if the economic momentum in Canada is markedly slower than it is in the U.S., the drum tight correlation between our bond yields and U.S. yields should weaken over time.
Canada
Our policy makers are determined to shift our economic focus away from real estate investment (and in my opinion, rightly so). The key question this year is what will replace our lost economic momentum from our real-estate related GDP growth?
Although the Loonie has weakened against the Greenback, so far that hasn’t helped our exports nearly as much as hoped. Benjamin Tal recently noted that U.S. manufacturers who buy our exports often use them in their own export-manufacturing processes. In these cases, as a stronger U.S. dollar weakens demand for their exports, it also weakens ours, even as their cost of our inputs is reduced. And while the Loonie has weakened against the Greenback, other currencies, like the Mexican peso, have fallen relatively farther, reducing the benefit of the tailwind that our cheaper currency would otherwise provide.
Our policy makers have repeatedly said that any sustainable economic recovery must be underpinned by a rise in business investment, particularly by our export manufacturers. But if they weren’t confident enough to invest in capacity expansion and productivity improvements before the election of President-elect Trump, should we expect them to be more so now when his main election platform centered around ripping up trade agreements and invoking protectionist trade policies?
Key Themes in 2017: Our economy needs to transition away from its focus on the real-estate related sectors that have fuelled an increasing share of our economic growth since the start of the Great Recession, and our policy makers are determined to do this. But the most important question this year is which sectors of our economy will emerge to replace that lost momentum. That is also the key question for Canadian home owners and mortgage borrowers in 2017 because our historical data show that job losses, not rising interest rates, have the biggest impact on debt default rates, and by association, house prices.
The key missing ingredient in the global economic recovery that has hovered just above stall speed since the start of the Great Recession in 2008 is business investment. Unfortunately, the over-riding theme that permeates the points made in this post is rising uncertainty. Against this backdrop, it is difficult for me to see businesses suddenly becoming more confident as we begin 2017, and since any increase in global economic momentum depends on increased business investment, I am less optimistic than the consensus view at the present time.
Five-year GoC bond yields have fallen by nine basis points since my last post, closing at 1.13% on Friday. Five-year fixed-rate mortgages are available at rates anywhere from 2.59% to 2.99%, with rates at the lower end of that range offered on loans that are eligible for some form of default insurance, and rates at the higher end of that range offered on loans that are not eligible. (If you want to learn whether you and your loan are eligible for default insurance , check out Part One and Part Two of my recent posts on this topic.) Five-year fixed-rate pre-approvals are now offered at around 2.94%.
Five-year variable-rate mortgages are still available in the prime minus 0.20% to prime minus 0.60% range, which translates into rates of 2.50% to 2.10% using today’s prime rate of 2.70%.
The Bottom Line: The silver lining in my view that uncertainty will hold back the global economy in 2017 is that bond yields do not typically rise when fear overtakes greed as the dominant market sentiment, and that should keep our mortgage rates at or below their current levels for a while yet. This view is based on the following assumptions: a) our regulators hold off on additional mortgage-rule changes that push rates artificially higher, and b) a global systemic economic event doesn’t cause investors to reassess sovereign debt as a safe-haven asset. Stay tuned.
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
January 9, 2017
Mortgage |