Dave Larock in Monday Interest Rate Update, Mortgages and Finance, Home Buying, Toronto Real Estate News
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Today’s economic data imply that our mortgage rates will stay low for the
foreseeable future. So much so that even the ‘end-of-low-rates-is-nigh’
forecasters at the Bank of Canada (BoC) have finally come around to the
lower-for-longer rate view.
Cue my contrarian itch, which reminds me of Bob Ferrell’s rule number nine
from his famous Ten
Market Rules to Remember: “When all the experts and forecasters agree –
something else is going to happen.”
Mr. Ferrell’s rule reminds me that markets have a long history of surprising
us and while the odds of rates staying low for some time yet are stacked in our
favour, make no mistake, the seeds that will eventually push rates higher
(perhaps dramatically so) are being sown in abundance.Bluntly
put, there is no historical precedent for what central banks are doing today.
Not even close. We are knee-deep into a period where these banks have become the
financial markets’ marginal buyers of sovereign debt, artificially suppressing
government bond yields and grotesquely distorting free-market forces.
This money-printing-by-another-name is politically expedient because it
allows over-indebted governments to continue running huge deficits and expanding
crippling debt levels that have, in many cases, been some seventy years in the
making. Consider the following:
- The U.S. Federal Reserve will buy about 90% of all newly issued U.S.
treasuries and mortgage bonds in 2013. (The U.S. Fed’s balance sheet was $800
billion in 2007, is about $2.8 trillion today and is expected to grow to $6
trillion by the end of 2015.) What happens when U.S. unemployment finally
reaches the Fed’s 6.5% target rate and the Fed wants to unwind its quantitative
easing programs? Do you think bond-market investors will be happy to fill that
huge void in demand by buying bonds priced at negative real-return yields?
money printing that it plans to continue until the Japanese economy reaches a
target inflation rate of 2%. But Japan’s bond yields are priced at microscopic
levels after two decades of deflation. While any positive yield is attractive in
a deflationary environment, if the BoJ is successful in creating 2% inflation,
today’s Japanese bond yields will have to adjust higher or they will produce
negative real returns. It already costs Japan 50% of its total government
revenue to service its national debt, and each one percentage point rise in
Japan’s cost of capital will cost the country another 25% of its total revenue.
Put another way, if Japanese government bond yields go up by 2%, Japan’s entire
tax revenue base will be needed just to pay its annual debt-servicing
sovereign debt issued by the euro zone’s distressed peripheral countries. The
ECB has mostly done this by recapitalizing banks so they could continue buying
their governments’ bonds, but now the plan is to just buy sovereign debt
outright in the secondary market under the Outright Monetary Transactions (OMT)
program. Whether the ECB has the will, or even the required backing, to do what
will ultimately be required to bail out Spain et al. is still an open question
that will continue to be tested by bond-market investors. It is only the
perceived strength of the ECB’s balance sheet that is holding down bond yields
in the euro zone’s imperiled peripheral countries.
By comparison, the BoC has not engaged in any quantitative easing since the
start of the Great Recession and our federal government enjoys one of the
world’s few remaining clean AAA ratings. But we are a small and open economy
that will not be immune from bond-market panic if a sovereign government
defaults on its debt.
If bond-market investors start to doubt the sanctity of government
guarantees, they may well demand higher yields for all sovereign debt. Then it
will be small consolation to say that our rates are among the lowest in the
world if they are significantly higher nonetheless. On the other hand, if the
U.S. Federal Reserve’s unprecedented monetary expansion eventually leads to
higher inflation, our deeply integrated and heavily U.S. dependent economy will
inevitably import that inflation.
As of today, these interest-rate threats are still distant. The risk of
sovereign default appears contained for the time being and the threat of U.S.
inflation does not seem imminent. For now. But every new dollar, yen or euro
that is printed or pledged is like another grain of sand being added to a pile
that history says will eventually collapse under its own weight. Most of the
experts I read think this will happen one way or another. Their only real debate
now is about the timing of the end result.
Government of Canada (GoC) bond yields were four basis points lower for the
week, closing at 1.48% on Friday. Five-year fixed-mortgage rates can still be
found in the sub-3% range and ten-year fixed rates are now offered at rates as
low as 3.69% (If rates do turn sharply upward, the ten-year fixed could make
those who took it look like geniuses – of the low cost-of-borrowing variety
Five-year variable-rate mortgages are available in the prime minus 0.40%
range for well-qualified borrowers and variable-rate price competition among
lenders is increasing.
The bottom line: When conservative Canadian borrowers evaluate the
range of possible interest-rate outcomes that await us on the distant horizon,
they are understandably concerned. They worry that at some point trying to save
money with variable-rate or short-term fixed-rate financing may be akin to
picking up a dime in front of a bulldozer.
My gut says that it will be higher inflation, not sovereign default that will
eventually push rates higher – but I still think the bulldozer is far enough
away to grab a few more dimes in the meantime.
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