How Unfolding Events in China Are Likely to Impact Canadian Mortgage Rates (August 31, 2015)

Dave Larock in Interest Rate UpdateMortgages and Finances

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China has been in the news a lot lately as it tries to shift its economic focus away from infrastructure spending and export-led growth toward increasing domestic demand and expanding its service sector. 

What is happening in China matters to Canadians, and specifically to Canadian mortgage borrowers, because China has been the marginal buyer of the world’s commodities for many years now. Our economic momentum is still highly correlated with changes in the global demand for commodities, and as such, even though we do not have much direct trade with China, we still keenly feel the impacts of its slowing growth rate.

The rest of world also watches its second largest economy closely and there have been two developments that have garnered a lot of ink of late.

First, earlier this month, China announced that it would devalue its currency after letting it rise for nearly a decade. There were differing opinions on why China did this. Some believed that China wanted to weaken its currency as a way to boost flagging export demand, which had dropped by an estimated 8.3% in July on a year-over-year basis. Second, others argued that China was trying to shift the yuan away from its well-established peg to the U.S. dollar, which is inconveniently high at the moment, and thereby allow it to move more freely in response to market forces. 

While both factors were probably at play, I believe that there is a third important factor: perhaps China’s primary goal was to make the yuan a more market-based exchange rate. China has been petitioning the International Monetary Fund (IMF) to include the yuan among its basket of official reserve currencies, and letting the yuan float was one of the IMF’s key conditions for this approval.

Regardless of China’s motives, other countries are also expected to devalue their currencies in response. Currency devaluation is a zero-sum game, often referred to as a ‘beggar thy neighbour policy’ because any related improvements in China’s export demand will come at the expense of other countries, leaving them little choice but to respond in kind. The U.S. dollar has surged of late and therefore the prospect of an East Asian currency war should decrease the odds that the U.S. Federal Reserve will raise its policy rate any time soon. A rate hike against this backdrop would push the greenback higher still and heap more suffering on U.S. exporters.

Although the U.S. doesn’t depend on exports as much as Canada does, sharp exchange-rate swings can be destabilizing for any economy. As a further complication, a weaker yuan also lowers U.S. import prices, further dampening U.S. inflation rates in the bargain and creating another undesirable side effect that the Fed would like avoid. 

The second major debate over China is whether its leaders will really allow its stock market to swing, sometimes wildly, as it works out its equilibrium, because China is still a country that prizes stability over all else. This test of China’s commitment to freer markets is made especially difficult in the current environment because China’s policymakers have injected huge amounts of stimulus into its economy over the past several years. With a new de-emphasis on infrastructure spending, that money has inevitably found its way into China’s stock market, creating an epic-sized bubble in the process. Instead of letting its stock market bubble pop, China’s leaders tried a series of clumsy counter measures, such as limiting short selling, restricting initial public offerings, and “discouraging” insiders from selling, among others.

These moves were harmful for two main reasons. For as long as they worked, which they only did for a short time, these interventions gave investors the impression that China’s policy makers would not let its stock market fall. This fostered the belief that investing in China’s stock market had no downside and  that in itself encouraged speculative risk taking. Even more damaging, though, was the fact that China’s panicked response undermined the image of its policy makers as a steady-guiding hand and cast doubt on the belief that they can use their formidable policy arsenal to effectively counteract the market disruptions that will inevitably occur as the country transitions to a more open economy.     

Taken together, the potential for an East Asian currency war and China’s failed stock-market policy test combine to make the global economy feel a little less stable. Against such a backdrop, demand for the U.S. dollar should continue to rise, and a stronger greenback makes it less likely that the U.S. Fed will raise its policy rate in the near future. (As a reminder, the Fed’s policy rate is expected to rise well ahead of the Bank of Canada’s overnight rate, so the Fed’s first rate rise will provide a kind of distant-early-warning system for our variable-rate mortgage holders.) 

An incremental rise in instability risks should also increase demand for safe-haven assets, like Government of Canada (GoC) bonds, and this should help keep our bond yields, on which our fixed-mortgage rates are based, at or near today’s levels for some time yet.   

The Canadian economy now stands at a potential crossroads. China’s demand for commodities has given our economy significant momentum and has helped to offset flagging U.S. demand since the start of the Great Recession. Now, as this critical momentum begins to fade, our economy is starting to benefit from improving U.S. demand for our exports. If both legs of this transition occur at the same time, history will show that our economy walked a very narrow tightrope indeed.

Sometimes it is better to be lucky than good. 

Five year GoC bond yields rose by thirteen basis points last week, closing at 0.74% on Friday. Five-year fixed-rate mortgages are still offered in the 2.49% to 2.59% 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 size of your mortgage and the terms and conditions that are important to you.

The Bottom Line: The Chinese economy has entered a period of slowing growth and rising instability. These factors should combine to make the U.S. Fed less likely to raise its policy rate in the near future, and by association, should help keep both our fixed and variable mortgage rates at or near today’s levels for the foreseeable future.

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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