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Last Wednesday, U.S. Federal Reserve Chairman Ben Bernanke made his
first public comments since warning markets several weeks ago that the
Fed could begin tapering its quantitative easing (QE) programs later
Officially, the Fed Chairman’s speech was part of a
conference being held by the National Bureau of Economic Research (NBER)
and Mr. Bernanke’s topic was titled “A Century of U.S. Central Banking:
Goals, Frameworks, Accountability”. Riveting stuff, I’m sure, but like
the opening act at a Bruce Springsteen concert the speech itself was
just a prelude to what people really wanted to hear. The main event came
during the question and answer period when Chairman Bernanke commented
on market developments since he cautioned investors three weeks ago that
QE would not continue forever.
(You can watch the video here on CSPAN. The Q&A session starts at the 28-minute mark.)
I provide a summary of what the Chairman said and how the market
reacted, let’s quickly review both how we got to this point and why
Canadian mortgage borrowers should care about changes in U.S. Fed’s monetary policy:
- Since the start of the Great Recession, the
Fed has adopted ultra-loose monetary policies which have included a 0%
short-term policy rate and three rounds of QE that have expanded the
Fed’s balance sheet from $870 billion in August 2007, to $3.5 trillion
in July 2013. A staggering increase that some analysts believe could hit
$9 trillion before QE is eventually wound up.
- The Fed’s main QE
objective has been to suppress bond yields in the hope that this will
stimulate growth and investment by lowering the cost of borrowing for
U.S. consumers and businesses.
- While the Fed has been successful
in lowering bond yields, these lower returns have significantly
increased the risk that asset and credit bubbles will form. When bond
yields are artificially suppressed, investors often take on increased
levels of risk to achieve their accustomed returns, and borrowers who
are encouraged by ultra-low rates to increase their debt burden are in
danger of being overextended when interest rates eventually rise.
the U.S. Fed embarked on its latest round of QE, it said that this
program would remain in place at least until the unemployment rate
dropped to 6.5% and provided that inflation did not rise beyond the 2%
- On June 19, at the conclusion of the Fed’s latest policy
meeting, Chairman Bernanke said that the pace of the U.S. economic
recovery was improving and that the Fed could begin tapering its current
QE program if that momentum continued. Markets reacted violently to
this warning, pushing bond yields and borrowing costs sharply higher
while the S&P 500 plunged by 5%.
That’s the situation we
found ourselves in when Chairman Bernanke stepped to the microphone
last Wednesday. But before we get to that, here’s a quick reminder of
why you should care what Chairman Bernanke has to say If you’re a
Canadian mortgage borrower:
- Our fixed-rate mortgages are
priced off of Government of Canada (GoC) bond yields, which have had a
98% correlation with U.S. Treasuries over the past five years. If the
Fed tapers its QE program and U.S. Treasury yields surge higher, higher
GoC bond yields and higher Canadian fixed-mortgage rates will quickly
- Our variable-rate mortgages are priced using the Bank of
Canada’s (BoC) overnight rate, which is currently set at 1%, while the
U.S. Fed’s comparable policy rate remains stuck at 0%. The BoC will find
it very difficult to raise its overnight rate any higher until the U.S.
Fed raises its policy rate because expanding the gap between these two
rates would drive the Loonie higher against the Greenback and heap
further suffering on our already beleaguered export-based manufacturers.
that the U.S Fed isn’t likely to even think about raising its policy
rate at least until its massive QE programs are completely unwound, I
think it will be some time before Canadian variable-rate borrowers have
much to worry about.
- Meanwhile, Canadian fixed-rate borrowers
live and die with each new hint of guidance offered by the Fed on the
timing of its QE withdrawal and/or each new related economic-data
With that in mind, here is what Chairman Bernanke
said about the Fed’s ultra-loose monetary policies after he finished his
prepared remarks at the NBER conference:
- While he was
surprised by the market’s reaction to his comments, Chairman Bernanke
felt that he had to remind investors that QE would not continue forever.
He was concerned that investors would “drift away” from the Fed’s
guidance and start operating under the assumption that QE would be
- The Fed is using its 0% policy rate and its QE
programs as its two main policy tools. QE is being used as a way to
provide short-term stimulus to the broader U.S. economy and the
improvement the Fed wants to see before unwinding it “has further to
go”. Meanwhile, the 0% policy rate is specifically trying to help lower
the unemployment rate, and it will not be raised “at least until
unemployment hits 6.5% [and] as long as inflation is well behaved”.
6.5% unemployment rate is “a threshold, not a trigger”. Achieving 6.5%
unemployment will merely provide a signal that it is “time to think
about the situation anew”. On that point, Chairman Bernanke added:
“Given that the unemployment rate understates the weakness of the labour
market and given where inflation is, I would suspect that it may be
well after we hit 6.5% before rates reach any significant level”.
Bernanke said that he thinks the current U.S. unemployment rate of 7.6%
“overstates the health of [U.S.] labour markets” and that both the
current employment and inflation data are saying “that we need to be
- There may be “gradual [and] possible
changes in the mix of instruments” used by the Fed to fulfill its dual
mandate of maintaining price stability and promoting full employment,
such as reducing QE, but that shouldn’t confuse people about the overall
thrust of policy the Fed’s policy, which will remain “highly
- “Higher accommodative monetary policy for the foreseeable future is what is needed in the U.S. economy.”
markets reacted favourably to Chairman Bernanke’s comments, with stocks
moving sharply higher while bond yields fell. Investor reaction was
also tempered by the release of the Federal Open Market Committee (FOMC)
minutes from the latest Fed meeting. This document revealed that there
is still much debate among the FOMC’s members about when QE should be
withdrawn. It supported the now growing belief that the Fed will be more
cautious in its approach to stimulus withdrawal than was widely
believed three weeks ago when Chairman Bernanke first reminded markets
that the Fed’s stimulus would not last forever.
Five-year GoC bond
yields fell by twelve basis points last week, closing at 1.75% on
Friday. This will stem the tide of further rate increases and should
lead to a tightening of the range of five-year fixed-mortgage rates on
Five-year variable rates are currently offered at discounts as low as prime minus 0.60% (which works out to 2.40% using today’s prime rate). Despite the recent run-up in fixed rates, the BoC’s Mortgage Qualifying Rate (MQR), which is used to qualify variable-rate borrowers, has held steady at 5.14%.
The Bottom Line:
Last week’s comments by U.S. Fed Chairman Bernanke provided further
support to my view that the Fed will taper its QE programs more slowly
than most market watchers are expecting. If I am proven right, both our
fixed- and variable-mortgage rates should remain at ultra-low levels for
the foreseeable future.
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