David Larock in Mortgages and Finance, Home Buying, Toronto Real Estate News
Last week the U.S. Federal Reserve replaced its pledge to keep its policy rate
in a range of 0.00 to 0.25% until 2015 with a pledge to keep its policy rate at
today’s emergency levels for “at least as long as the unemployment rate remains
above 6.50%” and for as long as inflation “is projected to be no more than half
a percentage point above the committee’s 2.00% longer-run goal”.
This is big news for anyone keeping an eye on Canadian mortgage rates.
Despite Bank of Canada (BoC) Governor Carney’s claims to the contrary,
Canadian monetary policy is closely linked to U.S. monetary policy because our
economies are so intertwined (we sell about 80% of our total exports into U.S.
markets). The higher Canadian interest rates get compared to U.S. rates, the
more demand there will be for Canadian interest-bearing investments. This, by
association, increases demand for our dollar and causes the Loonie to appreciate
still further against the Greenback, making our exports more expensive. Given
the deep and broad linkage between our two economies, if the U.S. Fed keeps its
policy rate nailed to the floor for years to come the BoC will have little
choice but to keep its comparable overnight rate (on which variable-mortgage
rates are based) very close to its current 1.00% level over that same
The Fed’s decision to change its policy-rate guidance from being time
specific to being data specific was really an attempt to give the market more
clarity around when will it eventually begin raising rates. Until the most
recent change, the Fed would just push the timeline for rate increases out into
the future as economic conditions worsened but this approach meant that
investors had to try to guess whether the Fed’s interpretation of the data would
be negative enough to warrant further extensions. In theory, tying future rate
increases to specific economic indicators could make the Fed’s future
interest-rate trajectory easier to predict, but upon closer examination I am not
convinced that this will be the case.
For starters, the U.S. unemployment rate is not always a reliable indicator
of the U.S. economy’s overall employment strength because it only counts people
who are actively looking for work. As such, it can be significantly impacted if
large numbers of people either enter or exit the job market (this is otherwise
known as a change in the “participation rate”). If employment picks up and people
who had given up looking for work become more optimistic and re-start their job
searches, the unemployment rate will rise, despite the fact that the employment
picture is improving. Conversely, if the job market worsens, more
disenfranchised people might stop looking for work, causing the unemployment
rate to fall, even though the job situation would actually be deteriorating.
To put this last point in perspective, if the participation rate falls
another 1.00% from today’s level, the U.S. economy could reach an unemployment
rate of 6.50% by sometime in 2013 even if there is no change in employment
growth. While fewer people looking for work would be a major negative, under
this scenario the Fed would have technically met its goal. The rise and fall of
the participation rate means that there will still be lots of room for
interpretation about whether changes in the unemployment rate are constructive
or merely technical.
Now let’s move on to the new million dollar question (or should we say
trillion dollar question given the current U.S. debt and deficit levels?): When
will the U.S. economy meet the Fed’s new unemployment rate target? Here are
several points to consider:
- The U.S. economy has produced an average of 139,000 jobs/month over the most
recent six months and to put that in perspective, it needs to produce about
150,000 new jobs each month just to keep up with its population growth.
- If the U.S. economy adds an average of 165,000 jobs each month for the next
thirty months, it should reach an unemployment rate of 6.50% by mid-2015. Of
course, this assumes that there is no increase in the U.S. participation rate,
which is at a three-decade low at the moment.
- To illustrate the impact that changes in the participation rate can have on
the U.S. unemployment statistic, consider that if the participation rate were to
rise by 1% over the next thirty months, the U.S. economy would need to average
238,000 jobs a month over that period to reach an unemployment rate of 6.50% by
The Fed itself expects the target unemployment rate to reach 6.50% by 2015,
which is interesting because its forecast is based on an average GDP growth of a
little more than 3.00% over the next three years. That GDP growth forecast,
which has been steadily revised downwards, is much rosier than any comments the
Fed has recently offered about the current U.S. economic situation. With either
the fiscal cliff or some negotiated budget compromise that includes a
combination of tax increases and spending cuts on the near horizon, a GDP growth
rate of sub 2.00% seems far more likely. Any realistic forecast that I have seen
recently calls for a GDP growth rate of 3.50% or higher over an extended period
as a prerequisite for an unemployment rate of 6.50%.
Side note: The Fed’s 2.50% inflation target is basically a non-factor
(It’s almost like the Fed threw that in as a token reminder that in more normal
times it would be focused on controlling inflation and maintaining price
stability instead of spurring job creation and trying to offset intransigence in
Washington.) To put this target in perspective, the Fed typically measures
inflation using its core Personal Consumption Expenditure (PCE) index, which
over the last twenty years has been north of 2.50% less than 2.00% of the time.
Consider also that the U.S. PCE core index has averaged 1.60% over the last
year, 1.20% over the most recent six months and 0.90% over the last three.
Five-year Government of Canada bond yields were eight basis points higher for
the week, closing at 1.37% on Friday. Five-year fixed rates are widely available
in the sub-3.00% range and when rates are this low, borrowers should pay special
attention to the terms
and conditions offered by each lender, especially those relating to prepayment
Variable-rate mortgages are still available in the prime minus 0.40% range
for borrowers who want to save money at the short end of the yield curve and who
are willing (and able) to accept the risk that their payments will increase.
While I think the variable rate is likely to be the cheapest way to borrow money
for the foreseeable future, we live in uncertain times and circumstances can
change quickly. As such, variable-rate borrowers should keep a close eye on the
interest-rate market or partner with an experienced mortgage planner who will do
this for them.
The bottom line: I
think the U.S. Fed has effectively extended the duration of its previous pledge
to maintain its emergency low policy rates from mid-2015 to at least 2017 or
2018. My old boss used to say that “the best indication of
the weather tomorrow is the weather today” when trying to predict what the
future would hold. Using that approach, if we assume that the U.S. economy
continues to average about 150,000 new jobs each month for the foreseeable
future, it will take until the end of 2018 before U.S. unemployment reaches the
Fed’s 6.5% target. If it takes that long, today’s variable-rate mortgages will
continue their long-standing streak as a Canadian borrower’s cheapest
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 (movesmartly.com) and on his own blog integratedmortgageplanners.com/blog). Email Dave