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The hot question surrounding bond yields and mortgage rates these days is whether the U.S. Federal Reserve is going to raise its short-term policy rate, called the “funds rate”, later this year.
The Fed funds rate is essentially the most important interest rate in the global economy. In normal times, it provides the Fed with its most effective monetary policy tool for controlling U.S. inflation and growth rates because it serves as the base rate on which all other U.S. interest rates are priced, either directly or indirectly. In extreme circumstances quantitative easing (QE) can have a greater short-term impact over U.S. interest rates, but QE is only used as a temporary, emergency measure.
Thus the Fed funds rate has a profound influence over the U.S. economy, which is the world’s largest. Given that bond yield movements in many other countries have a high correlation with U.S. bond yield movements, any change in the Fed funds rate initiates a cascading impact that permeates throughout the global economy. This impact is keenly felt in Canada, where our Government of Canada (GoC) bond yields have moved in lock step with their equivalent U.S. treasury yields since the start of the Great Recession, and this is why anyone keeping an eye on Canadian fixed mortgage rates should keep a watchful eye on the Fed’s policy guidance.
Now on to the question of the day: Will the Fed finally raise its policy rate for the first time since 2006?
At the moment, the market thinks that it will. In fact, bond traders who speculate on such things are now betting that the Fed will raise its funds rate in September. This belief is underpinned by steadily improving U.S employment data over the past year. Specifically:
- The U.S. economy has added more than 200,000 new jobs for eleven straight months, which marks its strongest period of new job creation in twenty years.
- That momentum has increased even further of late, with the data showing that U.S. economy added more than a million jobs over the most recent three months (after recent upward revisions to the initial November and December U.S. employment data estimates). This marks the best three-month run of U.S. job creation over the past seventeen years.
- One of the main criticisms of the improvements in the U.S. employment data has been that wages have not been growing along with the demand for labour, but that too is changing. U.S. wages have now grown by an average of 2.2% over the most recent twelve months, and while that may not seem like an impressive number at first glance, it is well above the 0.8% U.S. inflation growth rate, as measured by the Consumer Price Index (CPI) over the same period. This means that the purchasing power of the average American worker is now expanding, albeit at a modest pace, and this improvement is critical to the U.S. recovery because American consumers account for a very large and increasingly important part of overall U.S. GDP growth. Interestingly, the experts I read argue that wages are a lagging indicator and that the Fed will risk keeping its funds rate too low for too long if it uses average wage growth to determine when it should tighten U.S. monetary policy.
While there is no denying that the U.S. employment data have been improving, the contrarian in me is still skeptical about the market’s current bet on the Fed’s tightening timetable. Here are my concerns: