U.S. Default & Canadian Mortgage Rates

We’ve all heard about the impending fiscal calamity south of the border. The issue, of course, is whether lawmakers in the U.S. will increase the $14.3 trillion debt ceiling by August 2 (or thereabouts) so the U.S. can pay its bills.


That’s got many Canadians concerned about how this mess will impact interest rates north of the border.

From the looks of things, it’s not quite panic time. The odds are good that U.S. lawmakers will come to an 11th hour agreement if you believe what yields in the $13.5 trillion dollar treasury market are telling us. The benchmark 10-year U.S. note has remained calm, barely moving in the last few weeks. Most other credible sources, including the Bank of Canada’s Mark Carney, also expect a resolution by the deadline.

That said, the outcomes at this point are completely uncertain for two reasons: 1) There’s no assurance that Republicans and Democrats will come to terms in time; and 2) a default is totally without precedent in the U.S.

TD’s chief economist Craig Alexander writes, "The impact on Canada could range from a hiccup in our base-case economic outlook, to one in which we are thrown back into a recession that could have a global reach."

If the U.S. can’t meet its obligations on time, TD senior economist James Marple says simply: “We have no idea how bad it could be.”

Neither do we. Nonetheless, we’ve taken our best guess at two of several possibilities and their potential implications:

Possibility #1: The debt ceiling is raised on time

The good news: A crisis would likely be averted (for now). A Democrat/Republican compromise buys time for the U.S. to figure out how to stem its red ink. This predicament might even provide enough incentive to make headway towards balancing the U.S. budget (which would have a downward influence on North American interest rates long-term).

The bad news: The world has been lastingly reminded that U.S. government debt is not as “risk-free” as once thought. The rating agencies may give the U.S. a limited amount of time to put forward a credible deficit reduction plan. If it doesn’t, America’s haloed “AAA” debt rating could eventually be cut. That could shock financial markets and put us back in crisis mode.

Potential Interest Rate Impact: A Democrat & Republican debt deal would likely entail a slashed U.S. budget. That could slow the economy and weigh down yields. Rates could be further influenced by:

1.A ratings cut:

◦If the debt ceiling plan is deemed too risky by the market, ratings agencies could cut America’s debt rating, driving up yields up in the short term. The rate spike could be severe in the short term but probably not extreme in the long term (given the liquidity of the American debt market and the U.S. dollar’s primary reserve currency status).

◦We seen TV analysts speculate that the short-term impact would be a 50+ basis point spike in long-term U.S. rates.

◦U.S. yields might then settle down to roughly a 25 basis point premium over today, suggests Blackrock Analyst Rick Reider.

◦Canadian and U.S. bond yields are 95% correlated. As a result, our treasuries would likely reflect a portion of that increase (at least in the short term). That would boost fixed mortgage costs here by some fraction of a percent.

2.Budgetary progress:

◦If the U.S. eventually tabled a balanced budget, yields could drop back down (somewhat similar to how they did in Japan after its 2002 ratings cut).

Possibility #2: The debt ceiling is not raised in time

The good news: In simple terms, there are two types of government default: default on debt obligations and default on non-debt obligations (wages for government employees, the military, social security, etc.). The most crucial priority in the short-term is making principal and interest payments to holders of U.S. treasuries. Fortunately, the U.S. can still pay bondholders for a period of time. That means an actual “debt default” would likely be averted, hopefully long enough to permit a resolution.

The bad news: As the U.S. Treasury states, an impasse after Aug. 2 would merely be “default by another name.” The U.S. would undergo a severe fiscal shock with most of the government shutting down. America’s debt rating might very well be cut, thus driving up yields (and hence fixed mortgage rates). Canada’s economic outlook could be downgraded as well since we’re such a huge trade partner with the Americans.

Potential Interest Rate Impact:
•Long-term U.S. rates would soar in the short-term.
•Canadian rates could follow in sympathy, but to what degree is unknown. (Longer-term bonds lead fixed mortgage rates)
•To battle the economic contagion, the Bank of Canada would leave our overnight rate lower than it otherwise would. That would likely keep variable mortgage rates low.
•In the short to medium term, default could spark a rocketing loonie (versus the U.S.) and put the brakes on the Canadian/global economy. That would exert downward pressure on rates over time.
•Canadian rates might also be helped by asset rotation out of U.S. treasuries and into Canadian bonds. As more people buy Canadian bonds it lifts bond prices and lowers yields (and fixed mortgage rates).

*******

If another economic crisis does ensue, the odds favour variable mortgage rates over longer-term fixed rates.

If you’re a homeowner or prospective mortgagor who is concerned by all this, the best bet is to wait until next week and see how things play out. Then speak with a mortgage professional.

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Bank of Canada hints rate hikes are coming sooner rather than later

By Craig Wong, The Canadian Press

OTTAWA - The Bank of Canada signalled Tuesday that it will look for an opportunity to raise interest rates sooner rather than later to keep inflation in check as the Canadian economy continues to grow.

The central bank kept its overnight rate target at one per cent but noted that the U.S. economy has grown at a slower pace than expected and Europe faces a growing credit crisis — both potential drags on the domestic economy.
Despite those threats, the bank said it believes Canada's economy remains on track to grow this year, which observers said likely means a rate hike as early as October .
CIBC World Markets chief economist Avery Shenfeld said the bank's decision to drop the word "eventually" in reference to the timing of its next rate hike suggests it will move before the end of the year.
"The underlying message is that rate hikes will be coming sooner than eventually," Shenfeld said.
"The surprise is really for those who thought that the Bank of Canada would be waiting until 2012 to begin hiking rates, because I think here the message is directed at those dovish observers and indicating that we will probably be moving sooner than that."
The suggestion that rates in Canada will rise in the near term helped push the loonie up 0.88 of a cent to 105.17 cents U.S. — the highest close since the end of April.
Canadian economic growth slowed in the second quarter, but the central bank said it expects to see an acceleration in the second half of the year.
Overall, the Bank of Canada expects the economy will expand by 2.8 per cent in 2011, compared with its call in April for 2.9 per cent growth. The outlook for 2012 and 2013 was unchanged at 2.6 per cent and 2.1 per cent respectively.
Shenfeld said the central bank will likely wait to see if its economic outlook is on track before moving to raise rates.
"The key is the Bank of Canada has to see evidence that its projection for a re-accelleration in economic growth is actually taking place," said Shenfeld, who currently expects the central bank to hold rates in September and move in October.
BMO Capital Markets senior economist Michael Gregory said the case of a rate hike was building, noting that household spending in Canada remains solid.
"We are sticking to our call for October and December rate hikes this year," Gregory wrote in a note to clients.
However TD Bank economist Sonya Gulati said she continued to expect the Bank of Canada to keep rates on hold until its first meeting in 2012.
"We think that they are going to time it more to when the (U.S.) Fed is going to start to increase it, which we think is going to be March of next year," she said.
"In previous communications, the governor has indicated that the rate spreads between the two countries is something he's keeping a close eye on and that there has to be a working gap between the two for the countries to go forward, given how high the Canadian dollar is."
Gulati said TD expects the Bank of Canada will increase its overnight rate target in one-quarter percentage point intervals starting in January to two per cent before pausing to assess the situation and then increasing the key rate again to three per cent by the end of 2012.
A full update on the central bank's outlook for the economy and inflation is expected when the Bank of Canada publishes its monetary policy report on Wednesday.
The central bank said in its statement Tuesday that the U.S. economy continues to be restrained by the consolidation of household balance sheets and slow growth in employment while fiscal austerity measures in Europe also restrain growth.
"Widespread concerns over sovereign debt have increased risk aversion and volatility in financial markets," the central bank said in its statement.
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