Dave Larock in Monday Interest Rate Update, Mortgages and Finances, Home Buying
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What a difference a few weeks can make to the outlook for Canadian mortgage rates.
In the middle of September, our benchmark five-year Government of Canada (GoC) bond yield had surged thirty basis points to 1.73%, hitting its highest level since July, 2013.The mortgage market braced for the first across-the-board hike in five-year fixed mortgage rates this year, but then in less than a month, five-year GoC bond yields plummeted to 1.38%, marking their lowest level since May, 2013.
This heightened volatility was essentially the bi-product of a particularly intense fight between fear and greed in the hearts and minds of investors. In today’s post, I’ll outline why greed won a battle or two, and why fear is still winning the war.
Let’s start with a reminder. GoC bond yields tend to move in the same direction as their equivalent U.S. bond yields over time, and that correlation has tightened further since the start of the Great Recession. Since then, GoC bond yields have followed U.S. bond yields in lock step. Given that, changes in the U.S. outlook, and in investor sentiment toward the overall strength of the U.S. recovery, cause a direct and significant impact on Canadian fixed mortgage rates.
In mid-September our bond yields were surging higher and this was primarily caused by the growing belief that the U.S. recovery had finally achieved sustainable momentum:
- The U.S. unemployment rate continued to fall, but for the first time in a long time, this improvement was a result of more Americans actually finding work. Since the start of the Great Recession, most of the drop in the U.S. unemployment rate had previously been just a side effect of people giving up hope and withdrawing from the labour market altogether (and based on a data technicality, this meant they were no longer officially counted in the unemployment rate).
- Second quarter U.S. GDP growth was revised upwards for the second time, this time to 4.6%, bolstering the belief that the first quarter U.S. GDP slump of -2.1% was primarily the result of weather-related factors.
- The beleaguered U.S manufacturing sector continued to rebound, buoyed in part by falling energy prices (thanks largely to the U.S. shale-gas revolution).
- Business and consumer sentiment surveys continued to show gradual but steady improvement, as did many of the statistics tied to the U.S. housing market.
- The U.S. Fed continued to wind down its quantitative easing programs without disruption, abating market fears about the impact of this withdrawal.
But then a funny thing happened. As the skies cleared and U.S. economic prospects improved, the Fed started to talk more about interest-rate normalization. Not surprisingly, markets started pricing in a more aggressive Fed rate-hike schedule, and as worries over the potential impacts of higher rates mounted, investor sentiment began to turn more cautious. This marked the re-emergence of a vicious self-reinforcing cycle that I have written about before. Basically, the Fed is caught in a trap where positive economic momentum heightens rate-hike fears, and those fears kill the very momentum that created them in the first place.
This cycle will be hard to break and that challenge is made all the more difficult when the rest of the world’s largest economies are still in bad shape:
- The euro-zone recovery has fallen flat, and the next flare up appears imminent. Consider that Germany, France and Italy are its three largest economies, together accounting for 66% of all euro zone GDP. All three economies shrank in the second quarter and all are expected to show contraction again when the third-quarter GDP data are released. Most worryingly, with German economic momentum continuing to stall, the region is losing power to its main economic engine. Not surprisingly, we have recently seen increased volatility in government bond yields in the euro zone’s peripheral economies, and since key structural reforms have failed to materialize since the region’s last crisis, the euro zone is really no better equipped to withstand its next broadside than it was last time.
- In China, official forecasts call for GDP growth of 7.5% in 2014, which doesn’t sound bad until you consider that this would mark the country’s lowest growth rate in more than twenty years. China’s official statistics are often manipulated, so market watchers tend to use other data to get a truer gauge of the country’s real economic momentum, and these too portend a significant slowdown. For example, the Globe and Mail recently reported that power consumption, demand for steel, and demand for housing have all fallen recently. This has been unheard of over the last decade.
- Japan embarked on its most radical monetary policy path in history last year in an attempt to kick start its long stagnant economy, but many market watchers, myself included, were sceptical that this desperate gamble would pay off. A country with a staggering public-debt-to-GDP ratio of 240% doesn’t fix itself by adding more debt or by setting an inflation target of 2% that, if reached, would make the interest cost on Japan’s immense national debt equivalent to the entire tax revenue of the Japanese government. Japan enjoyed an immediate pickup in growth when it first announced its plans last year but that didn’t last long. The Japanese economy shrank by 7.1% in the second quarter of 2014 and all indicators imply more of the same when the country’s third quarter results are released next month.
- As if all of this economic malaise wasn’t enough to worry about, we also have rising geopolitical tensions with ISIS in the middle east, the ongoing Russia/Ukraine conflict and the economic drag of its accompanying sanctions, continued tensions between China and Japan, and most recently, shots fired along the North/South Korean border.
Throw in all of the hype about Ebola which, while quite possibly overblown at the global level, is still weighing on our collective psyche thanks to fear-mongering news media, and it’s easy to understand why investors are having hard time keeping their courage up.
There is no denying that the U.S. economy has shown improvement of late, and against that backdrop, one could argue that U.S. bond yields should be higher. David Rosenberg estimates that at its current 2% level, the ten-year U.S. bond yield is “priced for 1% growth, no inflation, and a return to an 8% unemployment rate” (up from 5.9%, where it stands today). But upward pressure on U.S. and Canadian bond yields is being offset by a flight-to-safety premium that intensifies each time the economic clouds beyond our borders darken. These forces are counteracting each other and that is why our bond yields have returned to lower levels than might otherwise be expected.
Five-year GoC bond yields fell ten basis points last week, closing at 1.42% on Friday. Five-year fixed-rate mortgages remain in the 2.79% to 2.89% range, and five-year fixed-rate pre-approvals are offered at 2.99%.
Five-year variable-rate mortgages are available in the prime minus 0.65% to prime minus 0.80% range, depending on the terms and conditions that are important to you.
The Bottom Line: Over the past month, U.S. and Canadian bond yields spiked because of incremental improvements in the U.S. economy, and then plummeted when heightened global economic fears caused a surge in demand for safe-haven assets. For now, these forces appear to be balancing each other out, however precariously, and that explains why our fixed and variable mortgage rates remain at today’s ultra-low levels.
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: integratedmortgageplanners.com/blog Email Dave