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Have the Fed’s quantitative easing (QE) programs now become permanent?
Before we answer that question let’s quickly review why Canadian mortgage borrowers should care:
QE matters to our fixed-rate borrowers because …
- There has always been a high correlation between Government of Canada (GoC) bond yields and U.S. Treasury yields, but it has grown even stronger since the start of the Great Recession. Over that period, the correlation between our respective yields has risen to about 90%. Thus, when the U.S. Fed artificially suppresses U.S. bond yields it is also suppressing GoC bond yields, on which our fixed-mortgage rates are priced.
- The level of the U.S. Fed’s intervention in the bond market has been unprecedented. Consider that the U.S. Fed now buys about 80% of all of the new bonds issued by the U.S. Treasury each month and that to do so, the Fed has had to quadruple the size of its balance sheet since the start of the Great Recession (to approximately $3.7 trillion today).
- The resulting impact on our bond yields (and our fixed-mortgage rates) has been substantial. For now. But if the Fed ever decides to start tapering, U.S. bond yields are expected to rise sharply and if/when that happens, GoC bond yields will be taken along for the ride. We got a taste of this over the summer when U.S. Fed Chairman Bernanke first introduced the word “taper” into his commentary. Our five-year fixed-mortgage rates rose from well below 3% to higher than 3.5% in the span of just a few weeks.
QE matters to our variable-rate borrowers because …
- U.S. and Canadian monetary policies are very tightly linked, essentially because we are each other’s largest trading partner and because our economies are so integrated through free trade. This means that, for all intents and purposes, the Bank of Canada (BoC) cannot raise its short-term policy rate (which we call the “overnight rate”) if the U.S. Fed doesn’t raise its equivalent federal funds rate (which we call the “target rate”). If the BoC were to raise short-term rates independently of the Fed, the Loonie would soar above the Greenback, causing the cost of our exports to rise prohibitively.
- Today the BoC overnight rate stands at 1%, which is already 1% higher than the U.S. Fed’s equivalent target rate of 0%. The vast majority of experts agree that this gap is already about as wide as it can realistically be.
- Thus, the BoC cannot raise its overnight rate, on which our variable mortgage rates are priced, until the U.S. Fed moves its target rate. And the Fed has repeatedly said that it will not even consider raising its target rate until it has completely unwound its QE programs. Therefore, if QE really is permanent, then you could at least make the argument that today’s variable rates will be as well.
Now that we’re clear on how the U.S. Fed’s QE programs are impacting Canadian mortgage rates and why you should care, let’s look at an evolving school of thought that argues that the Fed has no intention of tapering its QE programs – ever.
I first read this argument in an article written by Ben Hunt, a U.S. fund manager and analyst. He puts forward the following arguments:
- QE has become a new and permanent government program that is designed to provide Americans with deflation and growth insurance in the same way that Social Security, Medicare and Medicaid were previously designed to provide them with retirement and poverty insurance.
- The Fed’s decision not to taper its QE programs even when the world expected it to was “an intentional insertion of uncertainty into forward expectations” and was a warning “that the market should assume nothing in terms of winding down QE”.
- The Fed now says that both high unemployment and below-target inflation are individually sufficient reasons for continuing QE. Until recently the Fed had said that a U.S. unemployment rate approaching 7% would provide the key signal that tapering should begin. Now that the Fed has expanded its list of conditions for continuing QE to include below-target inflation, it is really “promising continued QE so long as economic growth is anaemic.” This means that QE is now being used to manage “garden-variety recession risks”.
- “Regardless of what political party may sit in the White House or control Congress in the years to come, it will be as practically impossible and politically unthinkable to eliminate QE as it is to eliminate Social Security or food stamps. QE is now a creature of Washington, forever and ever, amen.”
While this may sound like a radical argument, consider the following:
- The Fed is choosing to continue its current QE programs unabated, even though its own research shows that they are only having a minimal positive impact on the U.S. economy.
- Although the U.S. economy is still stuck in a rut, it is no longer in crisis. QE is radical monetary intervention that is only appropriate for depression-like economic conditions. By maintaining today’s QE levels in the midst of a low but steady-growth economic environment, the Fed is now clearly signalling its intentions to use QE as a status-quo policy tool.
- Over the past few months the U.S. federal deficit has fallen faster than at any other point in history. That means that the U.S. Treasury is now issuing fewer bonds each month than it was at the beginning of the year. By leaving its monthly QE purchases unchanged against this backdrop, instead of maintaining QE, in percentage terms, the Fed is actually increasing its easing effect.
- The Fed knows that the longer it continues to inject stimulus into the economy, the larger these injections will have to grow to maintain even today’s minimal impact. This comes at great cost because the bigger QE gets, the harder and messier it will be to eventually unwind and the larger the Fed’s balance sheet grows, the greater the global systemic risks become. The Fed knows this, but even at a time when the world was ready for it to dial back QE, it kept the pedal to its monetary metal.
- Today’s do-everything, fix-everything Fed regularly cites the need to offset what it sees as the continuing economic risks of bad fiscal policy, so the Fed is also now in the business of insuring the U.S. economy against domestic political failings as well. As long-time U.S. investment manager Michael Lewitt recently put it: “If you want Congress and the White House to establish "good" fiscal policy, then the last thing you want to do is provide an incredibly expensive insurance program against "bad" fiscal policy. It's moral hazard in the first degree …”
To summarize, the Fed now seems to be saying that it will continue its QE programs for as long as U.S. unemployment appears “unhealthy”, or for as long as inflation remains below target, or for as long as the politicians in Congress can’t agree, or for as long as the housing market is threatened by marginally higher rates, etc. One can only begin to imagine the lengths the Mom-and-Dad-know-best Fed will go to if it fears the U.S. economy might actually tip back into a cyclical recession.
GoC five-year bond yields were one basis point higher for the week, closing at 1.89% on Friday. Lenders have been slow to lower five-year fixed rates in response to recent drops, but if yields stay at current levels this should happen soon enough.
Five-year variable-mortgage rates are still being offered in the prime minus 0.50% range, which works out to 2.50% using today’s prime rate.
The Bottom Line: By its words and actions, the U.S. Fed seems to be quietly shifting the status of its QE programs from “temporary measure” to “permanent program”. If that’s true, our fixed-mortgage rates should remain very near today’s ultra-low levels for as long as the Fed continues to administer its monthly QE injections, and our variable-mortgage rates shouldn’t rise until sometime after that.
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