Monday Morning Interest Rate Update (August 27, 2012)

David Larock in Mortgages and Finance, Home Buying, Toronto Real Estate News

Mortgage Update Pic

The week ahead will be an important one for anyone keeping an eye on mortgage
rates because the world may look a lot different by close of business this

There are several important economic data releases scheduled throughout the
week, including second quarter GDP results for the U.S. (Wednesday) and Canada
(Friday), Canada’s employment report for June (Thursday), the release of the
latest U.S. Beige Book (Wednesday) as well as a slew of other U.S. indices
updates. But the real action will be in Jackson Hole, Wyoming, where the Federal
Reserve Bank of Kansas City is hosting central bankers from around the world at
its annual Economic Symposium.

Jackson Hole was where U.S. Federal Reserve Chairman Ben Bernanke outlined the
U.S. Fed’s plans for its second round of quantitative
in 2010 and for Operation
in 2011. As such, investors are expecting Chairman Bernanke to hint at
significant new stimulus measures when he steps to the podium this Friday at his
scheduled post-meeting press conference.

Here are the topics that the experts I read are anticipating he might cover
(with my comments on any potential impact on Canadian mortgage rates in

  • An extension of the Fed’s guarantee to hold its policy rate at 0% out to

Bank of Canada (BoC) Governor Mark Carney has long argued that Canadian
monetary policy can operate independently of U.S. monetary policy but this is
true only within narrowly defined boundaries. An extension of the U.S. Fed’s
near-zero percent policy-rate guarantee into 2015 should put to rest any talk of
any BoC rate hikes for the foreseeable future.

  • A third round of quantitative easing (QE3), whereby the U.S. Fed effectively
    prints new money and uses it to buy bonds in the open market.

If the Fed embarks on large-scale bond buying it should, in theory,
stimulate demand and investment by driving down bond yields and thus lowering
the cost of borrowing. But the impact of still lower borrowing rates will be
muted because rates have already been dirt cheap for some time and it’s hard to
imagine that any incremental lowering of borrowing costs at the margin will
stimulate a material increase in borrowing activity at this stage. Furthermore,
since most of the new money that was created during QE1 and QE2 has yet to start
circulating in the U.S. economy, injecting even more liquidity at this stage has
been likened to pushing on a string.

The only predictable outcome from QE3 is a further weakening of the U.S.
dollar, which while good for U.S. exports in the short term is really a
beggar-thy-neighbour policy that might well trigger another round of currency
wars. Given the relative strength of the Canadian dollar and the BoC’s decision
not to embark on quantitative easing, QE3 would in all likelihood further
strengthen the Canadian dollar. A stronger Canadian dollar would have a
dampening effect on our economic growth and as such, would reduce the likelihood
of BoC rate increases for the foreseeable future.

Under this program, the U.S. Fed would offer a lower cost-of-funds rate
to banks that increase the size of their loan books while charging a higher
cost-of-funds rate to banks that lend incrementally less.

This pay-to-play format would alarm those who are skeptical of any
government policy that attempts to actively direct market forces. Would an
incentive to lend (and a disincentive, or tax, for not lending) lead to a raft
of bad loans and/or sow the seeds of another credit bubble? Would the new loans
reach businesses and consumers who really need them, or would lenders just
further line the pockets of their well-heeled clients to avoid falling afoul of
the program? And most importantly, in a country awash in too much debt, won’t
stimulating the demand for more of it just prolong the painful and necessary
deleveraging process that is still inevitable?

I do not think a FLS program would prove effective over the long term
(although the immediate market reaction might be positive) and as such, I don’t
think the knock-on effects for Canadian mortgage rates would be significant.

  • A deeper commitment to Operation Twist, whereby the U.S. Fed sells
    short-term treasuries and simultaneously buys longer-term treasuries.

Operation Twist is designed to lower longer-term borrowing costs. While
it should also in theory raise shorter-term borrowing costs (which ‘twists’ the
shape of the yield curve) the actual impact on short-term yields has been
minimal because the Fed’s commitment to keep its policy rate lower for longer
has kept shorter-term U.S. treasury yields low regardless.

It was hoped that Operation Twist would stimulate demand for consumer
purchases of houses and cars, but the effect of the first two Twist rounds has
thus far been muted. Most economists remain skeptical about the impact of a
deeper commitment to the program and for that reason, I think this type of
initiative would have a minimal impact on Canadian bond yields (and by
association, our mortgage rates).

  • A reduction in the interest rate paid by the Federal Reserve for excess
    reserves being held on bank balance sheets.

This would increase the opportunity cost for U.S. banks that are holding
excess cash on their balance sheets and marginally lower the U.S. Treasury’s
interest cost. A lower return for these reserves may incent banks to redeploy
their excess reserves in the form of new loans but the real impact is expected
to be minimal in an environment where the preservation of capital is still of
greater concern than the return on capital. Given that, I think an announcement
that the U.S. Fed is reducing the interest rate it pays to banks on excess
reserves would have very little effect on bond yields and mortgage rates north
of the 49th parallel.

There is also speculation that European Central Bank (ECB) President Mario
Draghi may make a significant announcement at Jackson Hole when he gives a
speech about the future of the euro zone. One theory is that he will outline a
plan to cap Spanish and Italian sovereign bond yields, but it is hard for me to
imagine how the ECB would formally broach this topic before Germany’s
constitutional court rules on the legality of its participation in the European
Stability Mechanism (ESM) on September 12th. (The ESM is the permanent bailout
fund designed to replace the European Financial Stability Facility.)

We’ll find out soon enough.

Rate Sheet (August 27, 2012)Five-year GoC bond yields were down 9 basis points for the week, closing at
1.41% on Friday. Despite this, both RBC and TD raised their five-year
fixed-mortgage rates in an attempt to lead the market higher. It will be
interesting to see if other lenders follow suit, especially with the GoC
five-year yields now headed in the other direction. Market five-year
fixed-mortgage rates remain in the 3% range while sub-3% rates are still
available to high-ratio borrowers who know where to look.

Variable-rate borrowers can now access rates in the prime minus .35% range
(2.65% using today’s prime rate) but I still believe that one-year fixed rates
at 2.49% present a more attractive option to anyone looking to save money at the
short end of the yield curve.

The bottom line: I expect investors to be disappointed when U.S. Fed
Chairman Bernanke gives his press conference this Friday. The reason the U.S.
Fed is looking for creative solutions to aid the slumping U.S. economy is that
it used up all of its heavy artillery long ago. While we may well see a
short-term increase in GoC bond yields as investors shift out of bonds and into
equities in anticipation of a post-announcement stock-market rally, I expect any
effect on our yields (and by association, our mortgage rates) to be transitory.

Side note: If you’re in the market for a mortgage, check out my blog post
from last week called How
to Build Your Mortgage Bunker (while you still can…)
for a helpful tip that
will enhance your mortgage’s flexibility at no cost. Then, check back this
Wednesday for a second recommended tweak.

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 ( and on his own blog Email Dave

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