This is the beginning of the end of low interest rates. What does that mean for Canada's heavily indebted consumers?
If you’re old enough to have made a mortgage payment, say, a couple decades ago, then you likely remember a time when 8 per cent or even 10 per cent was a good mortgage rate.
Today, of course, that would seem insanely high. Mortgage rates have been coming down for decades. It hasn’t been entirely downhill the whole time, but the long-term trend is clear, and today you can get a mortgage in Canada for less than 2.5 per cent. That’s been good news for homeowners, who have seen house prices shoot steadily upwards. It’s been less good for new home buyers, who face high house prices, but who can still afford them (arguably) thanks to those low interest rates.
The Federal Reserve's funds rate has been coming down for more than three decades.
But that whole trend is coming to an end.
On Wednesday, the U.S. Federal Reserve hiked its overnight lending rate, the first rate hike in the world's largest economy in nearly 10 years. It's the beginning of a monetary tightening cycle that some experts say will bring to an end a 35-year-long run of lower and lower interest rates. In the coming years, the trendline on interest rates will be up.
In the words of Wells Fargo’s chief investment officer, Erik Davidson: “This is a major inflection point. The end of free money is in sight.”
Many experts say the world needs a return to more normal interest rates. Low rates are depressing returns on investment so much that billionaire financier Bill Gross recently advised that the best investment out there is ... cash.
"Cash or better yet 'near cash' such as 1-2 year corporate bonds are my best idea of appropriate risks/reward investments" in this low interest rate world, he wrote in an investment outlook in September. (Presumably he's talking about the rising U.S. dollar, not the sinking Canadian one.)
But when interest rates rise, many fear that the large run-up in asset prices that has been made possible in part by ever-cheaper borrowing costs may reverse itself as well.
The End Of House Price Growth?
Canadians needn’t wait for the Bank of Canada to join the Fed’s rate hike in order to feel the impact. Fixed-rate mortgages in Canada are dependent on Government of Canada bond yields, which have been moving in tandem with U.S. Treasury yields, and those rise when the Fed hikes rates. So a Fed rate hike can send Canadian mortgage rates up.
It’s not just mortgage-holders who should be concerned. Anyone who holds a large amount of debt, from governments to corporations to students, has good reason to keep an eye on where interest rates are headed next.
The Bank for International Settlements (BIS), a sort of “central bank of central banks,” says the world has taken on so much debt that a rate hike at the Federal Reserve could tip the whole planet into a debt crisis.
The BIS said the recent market instability — the Chinese stock market crash in particular — is a sign that the debt build-up around the world is now coming back to haunt the markets.
"We are not seeing isolated tremors, but the release of pressure that has gradually accumulated over the years along major fault lines," said Claudio Borio, the bank's chief economist, as quoted at the Daily Telegraph.
The BIS noted that total accumulated debt is higher today than it was before the start of the last credit crisis in 2008. The world has taken on an additional $57 trillion (yes, trillion) in debt since the last financial crisis, and as of the end of last year the planet collectively owed $199 trillion on a world economy worth about $80 trillion annually.
China alone has quadrupled its debt since the last financial crisis.
This debt binge is reflected in Canadian households, which in the past quarter saw their debt burden reach an all-time high. The average Canadian household now owes nearly $1.64 in credit-market debt, for every dollar of disposable income. That’s up from around $1 in debt for every $1 of disposable income at the start of the century 15 years ago.
An increase in interest rates could easily tank the Canadian housing market — and with it, possibly the entire economy, given Canada's outsized economic dependence on home construction (also at record highs). In fact, many economists say low interest rates are among the few things (along with foreign investors) holding up the Canadian housing market. Even as the total debt Canadians owe reached a record, interest rate payments, as a percentage of all expenses, hit a record low in Canada. Reverse those interest rates, and many won’t be able to handle their new, larger monthly payments.
Economist Will Dunning estimated in 2013 that a one percentage point hike in interest rates would lower Toronto home sales by 15.3 per cent over two years, and drop prices by 6 per cent. Even a half-percentage point hike would lower sales by 8.8 per cent and prices by 2.5 per cent. And those estimates are from two years ago, before Canadians’ debt loads reached current record levels. Even a small rate hike could turn the momentum in Canada’s housing markets decidedly negative.
A similar situation could play itself out in the numerous countries that have seen debt run-ups in recent years. Virtually the entire world is threatened by rising rates.
So Why Are Rates Rising?
Good question. In simplest terms, if interest rates are too low, your retirement pension won’t cover your costs in retirement. Your education fund for your kids won’t return enough to keep them out of debt. Investors won’t lend enough to businesses for those businesses to grow as they need to. And so on.
Many economists feared for years that extremely low interest rates, coupled with the Fed’s quantitative easing program (buying government debt and replacing it with cash in the economy) would cause massive inflation and distortions in the economy.
Years later, there is little evidence of that massive inflation. But evidence of economic distortions is beginning to build. Cheap credit is causing money to go to the wrong places. Why invest in new industries and new jobs when you can make better money buying residential properties in Vancouver or San Francisco or Sydney?
In that note where he extolled the virtues of cash, Bill Gross warned that years of low interest rates are making pretty much all investments kind of crappy.
“The Fed is beginning to recognize that six years of zero bound interest rates have negative influences on the real economy – it destroys historical business models essential to capitalism such as pension funds, insurance companies, and the willingness to save money itself,” Gross wrote.
“If savings wither then so too does its siamese twin — investment — and with it, long term productivity — the decline of which we have seen not just in the U.S. but worldwide.”
Gross thinks the Fed should have fired its gun last spring, and waited too long. A normal, sustainable prime lending rate (which Gross pegs around 2 per cent) “now cannot be approached without spooking markets further and creating self-inflicted financial instability,” he wrote.
Federal Reserve Chair Janet L. Yellen speaks during a press briefing at the Federal Reserve June 17, 2015 in Washington, DC. (Getty Images)
That panic was perfectly encapsulated in a recent headline at a popular business blog that declared the Fed “would be deeply nuts to raise rates now.”
That blog makes some decent points, most of which come down to the argument that the U.S. job market isn't strong enough yet for a hike. But is it “nuts” that, after nearly seven years at zero, the Federal Reserve wants to return to something even vaguely approaching a normal monetary policy? Or is it actually “nuts” that people should think that an interest rate of 1 per cent — which just a decade ago would have been so low as to overheat the economy into the upper stratosphere — is too high, and justifies market panic?
That’s the world we are now in. If we don’t raise interest rates, we risk watching the global economy sputter and fizzle over the coming years. If we raise rates, we run the risk of a market crash and a credit crisis.
It’s a typical stuck-between-a-rock-and-a-hard-place scenario, and Yellen is betting that liftoff is better than being stuck on the tarmac.
Batten down the hatches, and lock in that long-term rate.
An earlier version of this article appeared in September, 2015. It has been edited to reflect the Federal Reserve's decision to raise its overnight lending rate on Dec. 16, 2015.