Dave Larock in Monday Interest Rate Update, Mortgages and Finances
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Last Wednesday the U.S. Federal Reserve finally gave the markets what they had been nervously waiting for by removing the key word “patient” from its interest-rate policy guidance, but in my opinion, not for the reason that had long been expected.
Before we break down the Fed’s latest comments and I explain why I write that, let’s quickly review why what the Fed says matters to Canadian mortgage borrowers.
Canadian monetary policy is heavily influenced by U.S. monetary policy because our economies are deeply interlinked (we export about 80% of what we sell abroad into U.S. markets), because the U.S. economy is about ten times larger than ours, and because the Fed funds rate is essentially the global economy’s single most important interest rate (which I recently wrote about here).
There is always a delicate balance between the relative monetary policy positions of the Bank of Canada (BoC) and the U.S. Fed, and even subtle changes in our respective outlooks can influence the U.S/Canada exchange rate, which has its own profound impact on our economic momentum.
The most recent Canadian example of this phenomenon was seen when BoC Governor Poloz expressed repeated concerns about the negative impacts of sharply lower oil prices on the Canadian economy. His comments helped drive the Loonie lower, giving our exporters a competitive boost in the process.
Last week it was the Fed’s turn, as it offered markets its latest perspective on the strength of the U.S. recovery. Each Fed statement is carefully parsed by investors, who try to determine when it will finally begin to raise the funds rate from its current 0% to 0.25% range, where it has hovered since December 16, 2008. The funds rate is important because it acts as the base rate on which all other U.S. interest rates are either directly or indirectly based, so when it rises, almost all other U.S. rates would be expected to follow (along with rates in many other countries as well).
Investors have long expected that the Fed would first remove the word “patient” from its interest-rate guidance as an early-warning signal that its policy rate would begin to rise in the not-too-distant future. That expectation is based on precedent because in January of 2004, the Fed dropped the word “patient” from its forecast and then hiked its funds rate six months later.
Interestingly, the Fed did finally do exactly that last week. But in an unexpected twist, the tone of its overall communication was actually more cautious. So while the momentum of the stock and bond markets in the lead up to the Fed’s announcement last Wednesday was bearish, consistent with the removal of the word “patient” from its guidance, markets were quickly re-priced with a lower-for-longer interest-rate view immediately following the Fed’s actual announcement. Markets quickly lowered the odds of a September rate hike from 53% to 38%, and decreased the odds of a rate hike by year end from 77% to 64%.
Here are the key points from the Fed’s official statement along with the highlights from its latest U.S. economic forecast:
In her accompanying commentary, Fed Chair Janet Yellen added the following insights:
The Fed’s communication strategy at last week’s meeting raises an important question. It knew that markets would view the removal of the word patient from its policy language as a signal that the funds rate was likely to rise in the near future. But instead of using this key inflection point to produce the desired response, the Fed seems to have shaped the rest of its commentary to directly counteract that very reaction. Why?
I think the Fed has decided to go the way of the BoC and get out of the forward-guidance game (which I wrote about recently in this post).
Forward guidance was adopted at the onset of the financial crisis as a way to calm markets, but continuing to use that approach in this extended era of ultra-low rates risks making speculators over-confident about placing bets that could end up threatening the stability of the U.S. financial system. Given that, I think the Fed has decided to reinstate some of the mystery that accompanies its actions in order to create just enough uncertainty to give those would-be speculators pause before continuing to leverage their bets with today’s super-cheap money.
This belief is based in part on the fact that when Fed Chair Yellen recently testified before congress, she said that removing the word “patience” from the Fed’s policy commentary would merely mean that the Fed could then raise its policy rate after its next two meetings, but not necessarily that it would.
From my point of view then, the Fed’s removal of the key word “patient” from its policy language is a shift away from its forward-guidance strategy, rather than the much-anticipated signal that U.S. rates rises are imminent.
Five-year Government of Canada bond yields fell by twelve basis points last week, closing at 0.72% on Friday. Five-year fixed-rate mortgages are offered in the 2.59% to 2.69% range, and five-year fixed-rate pre-approvals are available at rates as low as 2.69%.
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: Despite removing the word “patient” from its interest-rate guidance, the Fed sounded decidedly more cautious in its views on overall U.S. economic momentum at its meeting last week. This is important for Canadian mortgage borrowers because BoC Governor Poloz has repeatedly said that he expects that the BoC will lag the Fed’s monetary-policy tightening timetable, making the Fed’s evolving interest-rate view a sort of distant-early-warning-system for when our mortgage rates may be heading higher. Given that the Fed’s comments last week imply that U.S. rates are (once again) likely to stay lower for longer than had previously been expected, by association, this implies that both our fixed and variable mortgage rates will do the same.
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