Monday Morning Interest Rate Update (November 12, 2012)

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

Mortgage Update Pic

Now that the U.S. election is over, markets will shift their attention back to
the European Union (EU), and more specifically, the 17 of its 27 member states
that share the euro as their common currency, known as the euro zone.

But first, some readers might be wondering why I have devoted so much ink to
the euro-zone crises over the last year, especially considering that the entire
EU buys less than 5% of Canada’s exports. Here are three reasons:

  • Investment markets are dominated by either fear or greed and over the last
    several years, fear has ruled the average investor’s mindset. Government of
    Canada (GoC) bonds are on a very short (and continuously shrinking) list of
    safe-haven assets, and this special status has fueled unprecedented demand that
    has driven these yields down to today’s ultra-low levels. The euro-zone crisis
    has been the primary contributor to the ‘fear premium’ that is currently priced
    into GoC bond yields, and since our interest rates are priced in relation to
    these yields, Canadian mortgage rates have a very direct link to ongoing
    euro-zone developments.
  • The EU is the largest single market in the world, accounting for 20% of
    global GDP. Not surprisingly, the EU is the largest buyer of U.S. exports and
    well-known Canadian economist David Rosenberg recently estimated that there is
    an 86% correlation between the performance of the U.S. and EU economies. While
    we are not directly dependent on EU export demand, we have a strong indirect
    link because we both have deep connections to the U.S. economy.
  • The EU is also China’s largest customer, buying about 20% of its total
    exports. An extended economic slump in the EU will continue to slow China’s
    economic momentum and in turn, reduce Chinese demand for commodities. China is
    the world’s largest marginal buyer of commodities, which means that commodity
    prices move in response to changes in Chinese demand. As such, our largely
    resource- and commodity-based economy has a second strong indirect link to
    events unfolding inside the EU.

Now that Floridians have finally finished counting their ballots and before
talk of the coming U.S. fiscal cliff pushes its way back up our worry list,
let’s check back in on the euro zone, which has been quietly fraying at the
edges of late.

The European Central Bank (ECB) met last Thursday and at the post-meeting
press conference, ECB President Mario Draghi offered some less than encouraging
comments. He offered a rather gloomy economic forecast, saying that he does not
see much improvement between now and the end of the year, while adding that
“looking ahead to next year, the growth momentum is expected to remain weak”
(despite this, the ECB left its main interest rate unchanged and offered no hint
that it was even considering future rate cuts).

The shocker for me was when Mr. Draghi said that the ECB was “more or less
done” helping Greece. While his comment was made as part of an argument that
euro-zone governments and their national central banks should take over
administering the Greek bailout and that the ECB’s hands were effectively now
tied, those words were a far cry from his earlier promise that the ECB will “do
whatever it takes” to save the euro. (On the Greek bailout file, I also note
that Greece must repay five billion euros of maturing treasury bills next week
at the same time that euro-zone leaders want to delay the country’s next bailout
payment until further proof of Greek compliance with its bailout terms is
provided and deemed satisfactory. The Greek tragedy continues …)

Mr. Draghi was candid in offering this overall assessment of the euro zone:
“We are observing a fragmentation of the euro area, re-nationalization of the
banking systems, [and] a difference in costs of funding that go beyond the

Speaking of the differences in costs of funding … the ECB and Spain are now
engaged in a game of high-stakes chicken. When the ECB recently created its
Outright Monetary Transaction (OMT) bailout fund, it was specifically designed
with Spain’s inevitable bailout in mind. But Spanish Prime Minister Rajoy isn’t
willing to formally request a bailout and submit to another round of austerity
measures until the ECB makes it clear at what bond yield level it will intervene
to support Spanish sovereign bonds.

In essence, Mr. Rajoy wants assurances that the ECB will keep Spain’s cost of
funding at manageable levels before he goes back to the electorate with more
budget cuts and tax increases. (Think of this as his wanting to do a political
cost/benefit analysis.) Despite being backed into a tight corner, he is using
the same approach that Greece tried to impose on its bailout negotiations,
hoping that fear of a Spanish default will give him some kind of
mutually-assured-destruction leverage. Mr. Draghi, for his part, seems to
believe that stalling for time will work in his favour (which it will, until
bond-market investors will no longer indulge him … and then it won’t.)

Despite the chaos around it, in the first years of the euro-zone crisis
Germany has fared remarkably well and that has given German Chancellor Angela
Merkel the political cover she needs to support various euro-zone bailout
measures. But on Wednesday of last week, Mr. Draghi acknowledged that while
“Germany has so far been largely insulated from some of the difficulties
elsewhere in the euro area…the latest data suggest that these developments are
now starting to affect the German economy.” This comment was backed up by data
showing a steep decline in German GDP growth (4.2% in 2010, 3.0% in 2011, 0.5%
in Q12012 and 0.3% in Q2 2012 and forecast to be lower still in Q3 2012).

Germany has been a reluctant participant in euro-zone bailouts to date and
the incremental cost of its continued support will only increase. Today, the
crisis is acting as a powerful drag on the country’s economic growth, but
eventually, as we see more bailouts with German backing as their centerpiece,
Germany’s prized credit rating will inevitably suffer and its cost of funding
will increase. This will make it increasingly difficult for Chancellor Merkel to
reconcile German interests with what is best for the euro zone, reminding me of
Luxemburg Prime Minister Jean-Claude Junker’s prescient quote: “We all know what
to do, we just don’t know how to get re-elected after we’ve done it.”

Five-year GOC bond yields were down two basis points for the week, closing at
1.30% on Friday. Five-year fixed-mortgage rates were largely unchanged and are
still available at around 3%.

Variable-rate mortgages have been gaining a little in popularity as
short-term fixed rates have increased. Borrowers can still find a five-year
variable rate with a discount of prime minus 0.40% (which works out to 2.60%
using today’s prime rate) and that offers a small savings over one-year fixed
rates which are now priced a little higher in the 2.64% to 2.80% range
(depending on the terms and conditions offered). While I still think paying a
small premium for the stability of a fixed rate makes sense for risk-averse
borrowers, the case for a variable rate is bolstered by increasing evidence that
rates could stay low for much longer than most experts have been forecasting.
But for the rate-driven borrower who can handle the risk of higher payments, the
variable rate may not have to concede its long-earned reputation for offering
the cheapest cost of borrowing over the long run just yet.

The bottom line: For the reasons list above, I believe that
ultra-low mortgage rates will continue to offer Canadians a silver lining for
the clouds that will otherwise darken our cloudy economic days ahead.

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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