The U.S. Fed’s Latest Insights and What They Mean for Canadian Mortgage Rates - Monday Morning Interest Rate Update (August 25, 2014)

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

Mortgage Update Pic

Gone are the days when central bankers act as invisible hands, which nudge economies back toward states of equilibrium as needed.

Since the Great Recession first sent shock waves that still echo today throughout the global economy, central bankers have taken centre stage. They now use their mighty (and bloated) balance sheets to purchase huge quantities of not just bonds, but also stocks. Central bankers now set the price for so many asset classes, either directly through outright purchases or indirectly through interventionist monetary policies, that these days, they are effectively the only game in town.

Did you know that the U.S. Federal Reserve, the Bank of Japan and the Bank of China have purchased 90 percent of all new U.S. Treasuries issued so far this year?

In an ironic twist, central banks have become concerned about their balance sheets being stuffed with so much low-yielding debt (of their own making), and in response, many are now purchasing equities in an attempt to diversify. Much like investors, central bankers want to reduce the risk that higher future inflation rates and consequent higher interest rates will trigger huge losses. But these market elephants can’t just wade quietly into the equity markets to balance their portfolios. Their tracks leave deep marks wherever they tread.

The U.S. Federal Reserve remains the market’s biggest elephant and last week we were offered two new opportunities to evaluate its current thinking. First, on Wednesday, we received the minutes from the latest meeting of the Federal Open Market Committee (FOMC), which is the group at the Fed that sets U.S. monetary policy. Then, on Friday at the Jackson Hole Economic Symposium, Fed Chair Janet Yellen  offered her latest assessment of the state of the U.S. labour market and her latest take on when the Fed may start raising short-term U.S. interest rates.     

As a reminder, U.S. Fed thinking matters to Canadian mortgage borrowers because U.S. and Canadian monetary policies are deeply linked. While most experts now believe that the Bank of Canada (BoC) will lag the Fed when short-term rates begin to rise, the timing of the Fed’s first rate hike still provides us with a kind of distant-early-warning system for the timing of the BoC’s next move.   

The latest FOMC minutes recognized “greater than anticipated” improvements in the U.S. labour market along with acceleration in overall inflation. The key takeaway from the FOMC’s most recent meeting was the growing disagreement among the FOMC’s members about when the Fed’s ultra-loose monetary policies should be replaced with more neutral ones. Several members are now calling for a “relatively prompt move toward reducing policy accommodation” and are expressing growing concern about the risks of “overshooting”, which basically means the risk in keeping rates too low for too long.    

Meanwhile, Fed Chair Yellen’s comments at Jackson Hole had a little something for everyone. And I think deliberately so. She expressed concern about the sluggish pace of wage growth and the still significant underutilization of labour resources, saying that “the labor market has yet to fully recover” from the Great Recession. Ms. Yellen acknowledged that it is now more difficult to judge the “degree of remaining slack” in the U.S. labour market, but she believes that “the economy remains unambiguously far from maximum employment” and is concerned that “the current level of the unemployment rate may understate the amount of remaining slack in the labor market”. The Fed Chair also addressed the decline in the unemployment rate, which would normally be interpreted as an encouraging sign from a healing labour market. Ms. Yellen said that today, “the decline in the unemployment rate … somewhat overstates the improvement in overall labor market conditions” and that “there has been little evidence of any broad-based acceleration in either wages or compensation”.

These comments offered fodder to anyone holding the view that the Fed will be in no hurry to raise short-term interest rates once it has completely unwound its quantitative easing (QE) programs this fall.

But Fed Chair Yellen wasn’t finished.

Understanding well that exuberant markets might take her cautious comments about the lack of apparent strength in the U.S. labour market recovery as a sign that low rates will remain in place as far as the eye can see, Ms. Yellen also highlighted factors that support a more bullish view. She acknowledged that rising wages may prove to be a lagging indicator and that “the current very moderate wage growth could be a misleading signal of the degree of remaining slack” in the U.S. economy. Ms. Yellen expressed concern about the potential for wages to eventually rise more quickly than expected and recognized that today’s long-term unemployed might not realistically be able to be reintegrated into the labour market. This would put upward pressure on wages long before the data indicated that the U.S. economy was returning to the historical definition of full employment, and given that, makes the Fed cautious about putting too much emphasis on traditional indicators.

Fed Chair Yellen closed with classic two-sided guidance. On the one hand, she said that if the labour market continues to progress more rapidly than expected, causing inflation to surge, “then increases in the federal funds rate target could come sooner than the Committee currently expects and could be more rapid thereafter.” On the other hand, Fed Chair Yellen reassured us that if U.S. economic momentum slows, “then the future path of interest rates likely would be more accommodative than we currently anticipate.” In other words, the Fed is taking a wait-and-see approach and will respond to market changes in either direction as needed. It’s no wonder that some observers get tired of hearing “on the one hand” and “on the other hand” and end up longing for a one armed economist.

When your words move markets, there are times when you need to speak without saying anything at all and I think Jackson Hole was one of the those occasions for Fed Chair Yellen. Her latest guidance gave just enough credence to both the hawkish and the dovish monetary-policy camps so as to balance the ammunition she gave to both sides. Given the uncertainty of our times, stalling for more time is a prudent play for as long as markets will let you get away with it. 

Five-year Government of Canada bond yields rose by seven basis points last week, closing at 1.55% on Friday. Five-year fixed-rate mortgages are available in the 2.79% to 2.89% range, and five-year fixed-rate pre-approvals are offered at rates as low as 2.99%.

Five-year variable-rate mortgages are available in the prime minus 0.75% to prime minus 0.60% range, depending on the terms and conditions that are important to you.

The Bottom Line: We remain in a state of limbo where it is hard to discern whether more upbeat economic data foretell a return to robust economic growth or are merely empty pangs emanating from a hollow recovery. While this uncertainty implies that neither fixed nor variable mortgage rates are headed materially higher any time soon, I still think fixed rates are now a better bet for most borrowers.

If you take a variable rate and you’re wrong about where rates are headed, your borrowing costs could potentially double over the next five years. But given the narrow spread between fixed and variable mortgage rates today, if you take a fixed rate and you’re wrong, your downside is likely to be far more limited and you probably won’t kick yourself too hard for having locked in a rate that was among the lowest in our history.   

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, Move Smartly, and on his own blog: Email Dave

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