Since the start of the Great Recession, Government of Canada (GoC) bond yields have been consistently pushed lower by wave after wave of troubling economic news from beyond our borders.
GoC bonds are part of a shrinking pool of available safe-haven assets and as economic fear and uncertainty have increased, so has the premium that international bond-market investors are willing to pay for those assets. Since our ever popular fixed-mortgage rates move in close relation to GoC bond yields, this fear premium has created a significant interest-cost saving for the majority of Canadian mortgage borrowers.Today, Japan is most responsible for recent increases in investor uncertainty. The Bank of Japan (BoJ) recently announced a new monetary stimulus package that would make even U.S. Federal Reserve Chairman Ben Bernanke blush (the same man who some have come to call Ben BernanQE). To put the latest announcement in perspective, consider that the BoJ’s balance sheet expansion will be equivalent to 30% of Japanese GDP over the next two years, as compared to the U.S. Fed’s expansion of 15% of U.S. GDP over the last five years. This is a radical and unprecedented shift from what had previously been a conservative central bank, and the impacts are already being felt around the globe.
The political pressure to do something of consequence in Japan was understandable. Thirteen years of essentially 0% policy rates have done nothing to reflate Japan’s low-growth economy and the BoJ has long been criticized for not providing enough monetary policy stimulus along the way. Recently elected Japanese Prime Minister Shinzo Abe was swept into office largely on a promise to right that perceived wrong and he has not disappointed his supporters, quickly appointing a new and compliant BoJ Governor, Haruhiko Kuroda, to do his bidding. But while Prime Minister Abe has won short-term political approval, he will ultimately be judged by the longer-term success or failure of his actions – and the ultimate outcome of these actions is far from assured.
Interestingly, when BoJ Governor Kuroda announced the Bank’s most recent new policy stimulus measures on April 4, Japan’s ten-year bond futures hit both a twelve-month high and a twelve-month low on the same day. (I’m no stock picker but GlaxoSmithKline, the maker of Tums, might just be in line for record sales next quarter.)
The consensus is that the BoJ’s actions will produce two primary outcomes – a depreciation in the Yen and an eventual rise in Japanese interest rates. Here are the implications for Canadian mortgage borrowers if those developments come to pass:
- If Japan weakens its currency, other over-indebted countries which are just as desperate to increase their export sales will follow suit. The list varies from immediate neighbours like South Korea and China to countries as far away as Brazil and Switzerland (not to mention the U.S., which essentially got this whole beggar-thy-neighbour party started in the first place). The Bank of Canada (BoC) has stayed clear of this developing currency war and as such, barring a change in BoC policy, the Loonie can be expected to strengthen further as the global currency war plays out. This would make future BoC policy-rate increases less likely and would even open up the possibility of a BoC rate cut to counteract the Loonie’s continued strength.
- If the BoJ achieves the 2% inflation rate that it has set as the target for its massive QE program, Japanese interest rates must eventually rise. Until now, 90% of Japan’s government bonds have benn domestically held, primarily by aging members of the population. (These bond-market investors were previously content with 1% nominal interest rates because, in Japan’s deflationary environment, real return rates were still 2.5% to 3%). If Japanese inflation rises to 2%, those retirement-age investors would face heavy losses. This expectation has understandably triggered a massive sell-off in Japanese bonds and fueled a wave of new demand for safe-haven assets (like GoC bonds).
While there was an overwhelming political will in Japan to do something in the face of their bleak economic prospects, Prime Minister Shinzo Abe should be careful what he wishes for. After all, if your economy is heading towards a brick wall, hitting the accelerator may produce a different result – but not necessarily a better one.
Kyle Bass is considered by many to be the foremost Japanese investment expert and he points out that if Japanese rates increase by only 2%, the interest cost on Japan’s immense national debt will be equivalent to the Japanese government’s entire tax revenue. As such, he believes that Japan’s new QE program has simply accelerated its path towards eventual default. The BoJ can only counteract market forces for so long – eventually those forces, and they alone, will determine the true price of a Japanese bond.
Five-year GoC bond yields slid down another three basis points last week, closing at 1.20% on Friday. These ultra-low GoC bond yields continue to translate into rock-bottom fixed rates, with five-year fixed-rate mortgages still widely offered at well below 3%. Will Federal Finance Minister Jim Flaherty soon be calling international bond-market investors to chastise them about their role in fostering sub-3% mortgage rates? I continue to think his time would be better spent working on the much talked about new mortgage-penalty disclosure rules that have been slow to materialize since first being promised in the federal budget two years ago.
Five-year variable-rate mortgages are being offered in the prime minus .40% to prime minus .45% range (which works out to 2.60% to 2.55% using today’s prime rate).
The bottom line: Japan’s massive new quantitative easing program has rattled bond-market investors to the point that it has even caused an increase in demand for Italian and Spanish debt. (Further proof that risk is always relative, I suppose.) It’s hard to believe that the euro-zone crisis is no longer the foremost fear driving bond yields lower, but there you have it. I guess Canadians will just have to live with these ultra-low mortgage rates for a while longer.