In the midst of the financial crisis, America’s equivalent of our central bank – the Federal Reserve- opted to lower its short-term overnight interest rates down to zero.Things did not stop there. The goal all along was to lower longer term interest rates, which are market driven and not directly influenced by the central bank. To do so, the Fed started purchasing vast quantities of U.S. government bonds and mortgage-backed securities in a program referred to as quantitative easing.

In doing so, the Fed effectively created new money and took bonds off the market and onto its balance sheet, with the goal of lowering long-term interest rates. The Fed actually went through a few cycles of quantitative easing, eventually balooning the Fed’s balance sheet to just over $4 trillion dollars, up from roughly $800 billion dollars, which is where their balance sheet stood pre-financial crisis.

By the first half of 2013, the central bank started making noises about easing off their quantitative easing initiative. After some false alarms, the actual taper was announced this past December.

Though they are not going to completely eliminate the process, their aim is to significantly pull back Specifically, the Fed will buy $75 billion of debt securities in January, with the aim of further reducing the purchases in future months.

What Does this Have to do with Canadian Mortgage Rates?

Well first of all, it’s important to understand the effect the scale back of the program has had on U.S. long-term bond yields. Quantitative easing aimed to suppress long term bond yields by purchasing large amounts of bonds. Bond yields move inversely in relation to prices, so any form of reversal of the easing would seem to put upward pressure on them.

What we actually saw happen was long-term U.S. bond yields actually rose during episodes of quantitative easing.

(if you would like a more explanation of why this happened, check out this commentary by Swiss money manager Franz Lischka.)

Even though the actual news of the easing o the process was only made official last month, the market started pricing it way back in May. As Michael Dolega, Senior Economist at TD Economics noted last summer, “The 10-year Treasury yield soared from roughly 1.65% before taper talk to about 2.80% in late August”.

As I write this article today, they sit at 2.86%.

U.S. and Canadian bond yields tend to follow each other pretty closely. Dolega has explained that, “Canadian rates tend to track U.S. rates due to the high level of integration of their economies and an implicit relationship in monetary policies”.

Moreover, the U.S. market acts as something of a “price setter” for the Canadian market, thereby leading the way. Generally speaking, higher U.S. bond yields, we have witnessed, will push Canadian rates higher, too.

Recall also that Canadian mortgage rates are heavily influenced by longer term Canadian bond rates. In fact, we have seen the 5 year fixed rate rise significantly since last May, when it was around 2.89%, to today’s 3.39%.

So putting this all together:

 

1. The expectation of the taper led to higher U.S. bond rates….
2. …which led to higher Canadian bond rates…
3. …which fed through into higher Canadian mortgage rates

A Curveball in 2014?

Market participants expect U.S. bond yields to keep rising in 2014, as a result of an (allegedly) stronger U.S. economy and further (expected) reversal of the quantitative easing by the U.S. Federal Reserve. This would in turn push Canadian mortgage rates up even further.

Is this a foregone conclusion and in any way shape or form a guarantee occurrence? Not at all. Investor expectations have been off before. What if current investor expectations are wrong again?

Another very plausible scenario bears considering. In the case that investors come to the realization that the U.S. economy is actually weaker than is currently perceive, they may start to believe that the taper will be abandoned and that short-term interest rates will stay near zero for longer. A taper-reversal could, in the short-run, send yields back down again sharply. In keeping with the process we described above. This would translate into lower Canadian bond yields and lower Canadian mortgage rates.

If history is any indication of the present or the future, any new round of quantitative easing could cause investors to flee U.S. Treasuries, in fear of future inflation. In this regard, it’s worth noting the lament of a former Fed official who told the Financial Times last year that, “We are looking at perpetual quantitative easing”.

Indeed, the big story of 2014 might just end up being just how overblown and premature all the 2013 taper talk really was.

What are your thoughts and comments? Please share, and feel free to contact us. We would love to hear from you

---

---

---

---

---

---

If you would like more information or a free consultation contact Aleem below, and as a Certified Mortgage Specialist let me help you get the home of your dreams. Great Mortgages, Made Simple

---