Dave’s Interest Rate Update for May 7, 2012

Guest Post By David Larock

When Bank of Canada (BoC) Governor Mark Carney recently warned market watchers that he believed mortgage rates will rise faster than most observers expect, he based this view on three fundamental predictions that were outlined in the BoC’s most recent Monetary Policy Report:

1.    The Canadian economy will return to full capacity in early 2013.
2.    The U.S. economic recovery is now on a more solid footing.
3.    The recession in Europe will end in the second half of 2012.

Given that Governor Carney and the BoC control our short-term interest rates (and can also heavily influence our longer-term interest rates), tracking the relative progress of these three developments will allow us to gauge the likelihood and timing of future rate increases. To that end, here is what happened last week on all three fronts.

Canada’s Production Capacity
The BoC’s most recent economic forecast called for our GDP to grow by 2.5% in the first quarter of 2012. This GDP forecast is closely tied to the BoC’s belief that our economy will return to full capacity in early 2013 because the faster we grow, the closer our actual rate of production is to its maximum potential. When our economy reaches full capacity, production costs rise and this creates price inflation. At that point, the BoC will normally raise short-term rates to slow borrowing and reduce demand for goods and services.

Conversely, a slower GDP growth rate would mean that it will take much longer for our economy to reach full capacity, lessoning the risk of inflation and reducing the pressure on the BoC to raise short-term rates.

Last Monday, Statistics Canada published its latest GDP report and it showed that our GDP actually shrank by 0.2% in February, a result that was below market expectations. This follows a disappointing January GDP report and the economists I read are now forecasting first-quarter GDP growth in the 1.3% to 1.6% range. That’s about half of what the BoC was predicting and as such, the latest GDP data should reduce the odds of sooner-than-expected rate hikes.

The Strength of the U.S. Recovery
The U.S. Bureau of Labor Statistics released its latest employment report last Friday and it showed that only 115,000 new jobs were created in March, down from 200,001 in February and well below the 150,000 new jobs the U.S economy must create each month just to keep pace with its population growth.

Despite this, the U.S. unemployment rate still dropped last month but that’s because this statistic only factors in people who are actively looking for work. In other wrods, this rate will fall in any month where the number of people who quit looking for work outnumber the newly unemployed. We saw this in the latest report when the unemployment rate fell from 8.2%to 8.1%, but only because the participation rate (which measures people actively looking for work) fell from 63.8% to 63.6%.

If the U.S. recovery is going to strengthen, U.S. consumers need to increase their spending; but if increased consumer spending is going to be healthy for the U.S. economy, it has to be driven by rising incomes, not decreased savings and more borrowing. Unfortunately, the recent rates of U.S. income growth have been among the slowest seen in the last 50 years, and the latest employment report showed a continuation of this trend.

Average earnings only increased by one penny, and the report showed that two-thirds of the new jobs created last month came from lower-paying part-time, retail, and restaurant and bar jobs. Meanwhile U.S. inflation is runing at 2.65% and as incomes fail to keep up with prices, the purchasing power of the average American continues to shrink.
I don’t think the U.S. recovery will find a stronger and more reliable footing until the U.S. economy’s rates of job creation and income growth are well above current levels.

The European Recession
We’ll go with a rapid-fire approach for this one:
On Monday of last week we learned that Spain’s GDP contracted by 0.3% in the first quarter of this year, matching its rate of GDP contraction in the fourth quarter of last year and extending the length of its second recession since 2009.

Overall unemployment in the euro zone reached 10.9% in March, the highest it has been in 15 years. France elected François Hollande as its new president yesterday. If his campaign rhetoric is to be believed, the Franco-German alliance that is so central to euro-zone stability will weaken. Greece has just elected a new parliament on a wave of anti-bailout sentiment. In their victory speeches, the two parties who won the most seats in what will be a minority government both promptly pledged to either renegotiate or overturn the bailout agreements. The contagion risk of a Greek default and/or withdrawal from the euro zone has been greatly diminished over the last several months but it’s hard to imagine a scenario where more Greek drama won’t occur and be bad for European business.

I disagree with all of three of the BoC predictions listed above, but the call on an end to the recession in Europe by the second half of this year seems the most dubious.

Five-year GoC bond yields were down 9 basis points this week, closing at 1.51% on Friday. The five-year yield is now back to where it was before the last round of mortgage-rate increases so that should exert some downward pressure on five-year fixed rates. The spread between five- and ten-year rates is still in the 0.6% range, which is well below the long-term average and still makes locking-in-for-longer an option well-worth considering.

Five-year variable rates are still too close to five-year fixed rates to justify their inherent risk, in my opinion. (I look forward to the day when I can stop retyping that last sentence!)

The bottom line:  I think last week’s developments on all three fronts make Governor Carney’s warning of higher-rates-sooner less likely to come to fruition. To be fair, Governor Carney tempered his prediction with lots of caveats about “heightened risks” and reassurances that any decisions would be “weighed carefully”.  In fact, since Governor Carney believes that our rising household borrowing levels present the greatest risk to our economy, it may actually be OSFI’s plans for tighter mortgage lending guidelines that make him less likely to follow through on his prediction (for a detailed analysis on the impact of OSFI’s coming changes, check out my latest Quarterly Mortgage Market Update.)

David Larock is an independent full-time mortgage planner and industry insider. Visit his blog for many more interesting articles and some great mortgage advice.


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This entry was posted by Marg on Tuesday, May 8th, 2012 at 5:36 am and is filed under Money Matters. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.

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