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When the minutes from the Fed’s latest Federal Open Market Committee
(FOMC) meeting were released last week, investors saw what they wanted
While the Fed is clearly determined to reduce the $85
billion of U.S. treasuries and mortgage-backed securities it buys each
month, its FOMC members remain cautious about the timing of this
The Fed has good reason for wanting to taper. Most
importantly because its latest quantitative easing (QE) programs do not
appear to have created much positive impact on U.S. economic growth.
Several of the economists I read regularly have long predicted that QE3
would only push ultra-low interest rates a little lower, and as such,
could only have a marginally positive economic impact. Meanwhile, QE3
has distorted market fundamentals, has undermined the world’s faith in
the U.S. dollar as the globe’s reserve currency, and has heightened
fears that the Fed’s bloated and expanding balance sheet is a ticking
time bomb that will destroy the prospects of America’s future
now that the Fed has put itself in this mess, withdrawing $85 billion
in monthly demand from the U.S. bond market is easier said than done.
For starters, that’s a lot of cheese (I think this graphic
does a good job of putting things in perspective). The U.S. Fed now
buys approximately 75% of all the new securities issued by the U.S.
treasury department. If the whole point of QE3 was to suppress
medium-term interest rates, what will happen to those rates when the Fed
stops being the marginal buyer of U.S. treasuries?
So far the
Fed’s tapering plans have only been a talking point, and bond yields
have already surged higher. Once the Fed actually reduces its treasury
purchases, how much higher will yields have to rise before there is
enough open-market demand to offset the enormous void that will be
created by the Fed’s withdrawal? Like many other observers, I think the
volatility that will accompany this process of “price discovery” has the
potential to undo most, if not all, of the limited positive economic
momentum that QE3 created.
To be clear, I don’t think the Fed is
tapering QE3 because its objectives have been met - as it claims.
Instead, I think the Fed is trying to beat a hasty retreat because a)
the cost of QE3 has far outweighed its benefits and b) the Fed has
always known that it could not continue to overpower market forces
Here are some additional thoughts on the all-consuming topic of the Fed’s tapering plans:
U.S. treasury department will issue fewer securities over the balance
of 2013, primarily because the U.S. federal government’s deficit is
shrinking. This means that the Fed will be able to reduce, or taper, the
amount of U.S. treasuries it buys while still buying the same
proportion (75%) of the treasury’s new issues. In other words, the Fed
will be able to buy less while leaving the current supply/demand balance
for new treasuries unchanged.
- By the middle of next year, the
U.S. Fed will have a new chairperson and may have as many as seven new
FOMC members (out of twelve in total). This significant turnover in
personnel will happen while the Fed is in the midst of trying to unwind
the largest QE program in U.S. history. Financial markets perform best
when the Fed’s actions are stable and predictable. Today we don’t even
know the names of most of the people who will be managing the Fed
through this tapering process.
- The Fed has insisted that it will
taper only if U.S. economic data continue to strengthen. Meanwhile, the
U.S. treasury has already hit its latest $16.7 debt ceiling and is now
funding itself with emergency cash reserves that should only last until
October or early November. If Congress pushes the treasury to the brink
of default, as it did the last time the debt ceiling limit had to be
raised, this will create a powerful headwind for U.S. (and global)
economic momentum. At this point, another round of brinkmanship appears
- U.S. new home sales declined by 13.4% in July,
marking the biggest decline in new home sales since May of 2010. This
seems to indicate that higher interest rates are having an immediate
impact on the U.S. housing recovery. And the Fed has said it will look
to that recovery as a key barometer when determining the timing and
extent of its tapering plans. When tapering actually starts, yields can
be expected to rise higher still, and this will further undermine the
U.S housing recovery. (I wrote in detail about the self-reinforcing conundrum that is inherent in tapering last week.)
while the Fed has tried to use staggering levels of QE in an effort to
suppress interest rates, research shows that the Fed is actually much
more effective at influencing interest rates when it simply offers
forward guidance on when it is likely to increase its short-term policy
rate. And this latter strategy costs the Fed nothing. Because of that,
when the Fed announces that it has begun to taper, I expect that it will
also extend its guidance on the timing of future short-term rate
increases as an offset, in the hope that this will keep bond yields at
least partially anchored.
If you’re a Canadian variable-rate mortgage borrower, that announcement will be welcome news. As I have written in many a Monday Morning Update,
the Bank of Canada (BoC) isn’t likely to raise its overnight rate, on
which our variable-rate mortgages are based, until the Fed increases its
comparable short-term policy rate. This is because our economies, and
our monetary policies, are tightly linked. As such, if the BoC were to
raise before the Fed and cause the gap between Canadian and U.S.
short-term rates to widen further, the Loonie would appreciate against
the Greenback and heap further suffering on our already beleaguered and
Conversely, if you are in the market for a
five-year fixed-rate mortgage, which moves in conjunction with the
Government of Canada (GoC) five-year bond yield, then the results of the
interplay between the Fed’s decision to begin tapering and its attempt
to anchor medium-term rates by extending its forward guidance will be
less certain. Given that, I expect the ride for prospective five-year
fixed-rate borrowers to be much bumpier.
Five-year GoC bond yields
were two basis points lower for the week, closing at 1.94% on Friday.
Despite this small decrease, the Royal Bank of Canada led fixed-mortgage
rates higher by raising rates across the board. Five-year fixed rates
are now offered in the 3.50% range and ten-year fixed rates are now only
available at rates above 4.00%.
Five-year variable rates are
still offered in the prime minus 0.55% range (which works out to 2.45%
using today’s prime rate), and this option grows increasingly more
appealing as the gap between five-year fixed and variable rates
continues to widen. That said, variable-rate borrowers will find it a
little harder to qualify for a mortgage after this Wednesday because the
BoC’s qualifying rate,
which is used to underwrite variable-rate applications, will also rise.
As a reminder, the BoC calculates the qualifying rate by taking an
average of the posted five-year fixed rates at Canada’s largest six
The Bottom Line: Financial markets continue to react
to every new hint about when the U.S. Fed will start to taper its QE
programs. While that volatility has once again pushed our fixed-mortgage
rates higher, it also bolsters my belief that variable-rates should
remain at current levels well into the 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