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The blind date

Saturday, October 15, 2016 23:03
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(Before It's News)

YOGA1

Like most babes, Michelle knows the way to my heart. “I’ve been reading your blog for a few years now and really appreciate your efforts to demystify some very important financial information,” she coos. “I’ve really come to appreciate how little the average Canadian understands about markets and investing, how simple it really can be if you take the time to learn the basics, and how much risk is involved in buying what should just be a place to live.

“Now that I’ve buttered you up, I’m hoping you will post some further information for us ignorant masses about interest rates.”

Ah, Michelle. You’ve picked a sweet week to open up a discussion on the cost of money. Come Thursday afternoon, there will be little else to yak about. History is about to happen.

“Recently, I had a conversation with my mom about–what else?–real estate, prices,” Michelle continues, “and what will happen if this party doesn’t end. Or it does end.

“Rates are staying low,” my mom said. “The BOC can’t raise them now.”

“That doesn’t mean mortgage rates won’t go up,” I said smugly, “Fixed-terms will go up when the US Fed raises interest rates, because fixed rates are set by the bond market.”

Did I sound smart? Because I have no idea what any of that means. How exactly does the bond market figure in? And had no answer to her question, “Then why do fixed rates go down every time the BOC lowers rates?”

Can you please explain? So I can feel smug again?

Yes, Michelle, you did good – right up to the ‘no answer’ part. Your mom is wrong, because while Canadian interest rates may stay in the ditch for a while, the era of awesomely cheap money is definitely coming to an end. More on that in a moment.

First, an answer to your smartass parent’s second question: fixed-rate mortgages fall (usually but not always) when our central bank lowers rates because the benchmark 5-year Government of Canada bond also falls. That happened back in January, but to a lesser extent in July. So a fiver mortgage dipped to an historic low point at the end of last winter, and has since swelled a little.

The reason this won’t hold for the future? Regardless of what the Bank of Canada does, what the Fed does matters more. History proves it. The Canadian bond market has followed the US debt market in close correlation 93% of the time over the past 25 years. And our central bankers, poodles that they are, have followed the lead of their American counterparts also more than 90% of the time over the same period.

Here, show this to Mom. Fed rate in dots, Bank of Canada in solid:

BANK RATE CHART1

Since December of 2008 US interest rates have been at low tide – in a range between zero and a  quarter point. This was an emergency situation created to mitigate a credit crisis by flooding the economy with cheap money. It was augmented by an aggressive Fed policy called ‘quantitative easing’ which saw Washington spend trillions buying government bonds and then shovel all that money into chartered banks with a mandate to lend like little wizards.

It worked. The US has created 13 million jobs in the past five years, corporations have recovered, deficits fallen and the economy repaired. All that stimulus was no longer needed, so the Fed ended QE last year (the macroeconomists who read this blog moaned it would never happen), and is now about to start raising rates.

Why? Because if rates stay this low inflation could roar back as wages and prices rise, plus asset bubbles emerge (real estate’s a good example). People like your mom think the cost of money will never rise, so why not borrow and spend? The solution to inflation, of course, is w-a-y higher interest rates, and nobody wants to go there.

Now once the US central bank starts to raise rates, it won’t stop – at least not for a couple of years. The expectation is that current level of under one quarter will end up being about 3% by the time this ‘tightening’ cycle is complete. The Fed types has indicated everybody should expect about 1% more per year. This could change if the economy heats up a lot (more hikes) or takes a China-induced hit (the hikes stop). In any case, up she goes.

The tricky part is when it might begin. That brings us to Thursday. The Fed may well pull the trigger that afternoon at 2 pm. If not, it will happen towards the end of October.

Lots of people think this week is the go-date because the economic data lately has been strong, the Fed has been patient long enough and more waiting won’t accomplish anything, plus Fed boss Janet Yellin doesn’t want to be seen delaying her decision because stock markets have been roiled. That’s what her predecessors often did, and she wishes to change course. Likely she will.

While everyone knows this is coming, it will nonetheless be a shock, Michelle. The world is drunk on debt after a decade of cheap money, and taking away the punchbowl won’t be easy. The US dollar will go up, commodities, our dollar and emerging market currencies will fall, realtors will quiver, stock markets will flop around like a landed carp and your mother will think the world is run by idiots.

She won’t be entirely wrong.

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