Is the U.S. Fed Making the Unthinkable Inevitable? (Monday Morning Interest Rate Update)

Dave Larock in Monday Interest Rate Update, Mortgages and Finance, Home Buying, Toronto Real Estate News  

Editor's Note: Dave's Monday Morning Interest Rate Update appears
on Move Smartly weekly. Check back weekly for analysis that is always
ahead of the pack.

Mortgage Update Pic

When the U.S. Federal Reserve met last week, it did as markets
expected and decided to continue buying $85 billion of newly issued U.S.
Treasury debt each month.

To put that number in perspective, the
Fed is now buying almost all of the new debt issued by the U.S.
Treasury. This means that the U.S. federal government is financing its
massive deficits in a closed system that is not subject to market
forces.

In simple terms, today, when the U.S. government needs
more money, it simply sends the bill to the U.S. Treasury department,
which then calls the Fed and asks it to fire up the printing presses for
the required amount. (Preliminary calls like this are a good idea
because it’s hard to keep enough ink on hand at the Fed these days.) No
need for any messy price discovery in the bond markets, which lets
investors determine yields according to the balance between supply and
demand.   

In
any other country it wouldn’t take long for this type of QE to end in
tears. Investors would simply wake up one morning and decide that they
no longer wanted to hold the profligate country’s debt, at any yield,
and a credit crisis would ensue with spiking bond yields, rampant
inflation and a massive currency devaluation. But America has long been
the world’s dominant economy and the Greenback is the world’s reserve
currency. This allows it to resist natural market forces for much longer
than any other country.

The special power of being the world’s
reserve currency can be plainly seen today. First, U.S. bond yields
should rise as the U.S.Treasury floods the market with new debt, but
they don’t because the Fed uses its closed system QE to buy the new debt
at artificially low prices. Second, those massive QE programs should
raise fears of future U.S. inflation and should cause investors to dump
their U.S. dollars in response, but they don’t because when a crisis is
looming investors crave two things: safety and liquidity.

Nothing
is more liquid than the world’s reserve currency and the US dollar, in
our lifetimes, has always been seen as a safe harbour. In a crisis,
demand for the U.S. dollar increases and the Greenback rises, even when
the crisis is of the U.S.’s own making. In this way, fear of the Fed’s
ongoing money printing and of higher U.S. inflation actually drives the
Greenback up, instead of down, and also increases demand for U.S.
Treasuries, which are still seen as a safe-haven asset. Counter
intuitively then, the destabilizing effects of QE actually trigger a
unique support mechanism for U.S. Treasury yields and the Greenback,
fueling an economic discount for both that more than offsets natural
market forces.

For now.

Eventually all chickens come home to
roost. It will probably take a long while yet, because the prospects of
the U.S. Treasury bubble bursting and of rampant U.S. inflation are
almost unthinkable. But as the Fed passes up each subsequent opportunity
to slow its massive QE programs the unthinkable inches a little closer
to becoming the inevitable. We live in interesting times.


Five-year
Government of Canada bond yields were up seven basis points last week,
closing at 1.78% on Friday. Despite this, both three- and five-year
fixed-mortgage rates are falling as lenders continue to adjust to the
falling bond yields we had seen several weeks prior.

Five-year
variable-rate mortgages are still offered in the prime minus 0.50%
range, which works out to 2.50% using today’s prime rate of 3.00%.
Several shorter-term variable rates are also attractively priced at the
moment.

The Bottom Line: Massive QE by the U.S. Fed has
been a boon to Canadian mortgage borrowers because it has kept our
fixed- and variable-rate mortgages at ultra-low levels for some time.
But the longer QE continues, the greater the risk that it will one day
push U.S. inflation sharply higher and trigger a spike in U.S. bond
yields. I think that the U.S. dollar’s special status as the world’s
reserve currency, along with the world’s continuing faith in U.S.
Treasuries as a safe-haven asset, will allow the Fed to continue on its
current course for some time. Canadian mortgage borrowers will continue
to benefit for as long as it does, but we would be wise to remember
economist Herb Stein’s famous quote: "If something cannot go on forever,
it will stop." Eventually …

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

Buying     |     Mortgage     |     Market     |    

Toronto’s most authoritative real estate insights, delivered right to your inbox.