Why are mortgage rates going up?

I earlier stated that posted rates are irrelevant, but the change in them is somewhat more relevant. The change in mortgage rates, however, are dictated by the Canadian government bond market.

5-Year Canada Government Bond Benchmark Yield

As you can see, the 5-year government bond yield is at a high for the year – at 3.06%, it has not been this high since October 2008.

Today some of the major banks increased their posted rates to 6.1% from 5.85%. The best market rate you can receive today on a 5-year fixed mortgage, without going through too much hassle, is around 4.25%. This will likely go up to 4.5% soon.

Over the past 5 years, the peak for the 5-year benchmark government bond yield was 4.72% in the week of June 13, 2007. The posted bank rate then was around 7.3%, and a typical market rate on 5-year fixed rates would have been around 5.8%.

As government bond yields continue to increase, mortgage rates will also follow.

Canadian Fiscal Monitor January 2010

This is about nine days late, but the Ministry of Finance released the fiscal results for the 10 months ended January 2010.

Of particular note is a massive increase in corporate income tax collections – up a whopping 74% for the month of January 2010, from January 2009. Although month-to-month results will be quite volatile in this category, for the 10 months from April 2008 to January 2009 and April 2009 to January 2010, corporate tax collections are still down 23%. This will inevitably be better in the 2010-2011 fiscal year.

The spending side of the ledger continues to be very high, with 12% growth for the 10 months to date.

Modern Finance – The risking of the risk-free rate

There will be a huge quantum shift coming in the financial markets, and this is mostly inspired by the fiscal mess that countries such as the United Kingdom and the United States will be facing in the medium term future.

It has to do with the concept of the “risk-free rate”. Most formulas in finance reference the US government bond or Eurodollar (essentially an interbank short term interest rate) as the “risk-free rate”, where all other financial securities are referenced from. So if the 5-year US government bond is trading at a 2.5% yield and General Electric issues 5-year debt at 3.2%, typically the financial literature would state that the bonds were sold at 70 basis points over. The spread of yield, rather than the absolute yield itself has typically been the market benchmark in determining how creditworthy a corporate issue is.

This is going to change, mainly because the risks inherent in the reference securities will be significant to the point that it will start to distort the concept of the spread.

It is very unlikely that the US government will default on their debt; instead, the road to their fiscal recovery will lie upon debasing their currency. An investor in General Electric would still face the same inflation risk as an investor in US government securities; however, the big difference in modern finance is that an investor can hedge their currency risk and solely take on the default risk of the security.

As a result, it will increasingly be seen that corporate bonds will be trading at lower yields than their government counterparts under the belief that the market thinks the corporation is more likely to pay off its investors than the government.

Thus, the finance variable of the risk-free rate must not be solely relied upon – just as how Newton’s Laws become unreliable when dealing with objects that are close to the speed of light, the risk-free rate becomes unreliable when sovereign defaults start becoming non-zero possibilities.

Quantitative traders that fail to adjust for this in their models will end up losing a lot of money for their clients.

Debt and confidence

John Mauldin summarizes a part of the book This Time is Different by repeating that a sudden drop in confidence is what drives economic crises. A lack of confidence is more pronounced in debt crises because if the market collapses for debt renewals, you will have to default, which triggers a worse cascade of events.

It is also difficult to predict when the confidence is lost, but when it does occur, it is usually sudden, as witnessed in the 2008 financial crisis.

Whether another financial-type crash will occur in North American markets is up for debate, but whenever such a crash happens, one is best to brace for impact in terms of one’s portfolio and personal financial situation – high debt leverage is the big killer.

Fiscal Monitor Canada – November 2009

Canada released the November 2009 Fiscal Monitor, which is not too different than the October release. However, the big exception is collections from GST, which is a very good proxy for retail consumption – while October 2009 to October 2008 was down 8.5%, in November, it was up 16.6% from November 2008. On a year-to-date basis, in October it was down 16.5%, while in November it was down 12.0%, a remarkable improvement, but still down from fiscal 2008.

Is retail spending increasing in Canada, or is this just statistical noise?

All other metrics, including personal income tax collection (a proxy for employment as most of the taxes collected are through payroll deductions), corporate tax collections (a proxy for corporate profitability) and GST collection (a proxy for domestic consumption) are down.

The other comment is that for the 8 months of the year, the fiscal trajectory suggests the deficit will be about $54.4 billion.

Bank of Canada getting nervous about debt levels

The Governor of the Bank of Canada in a recent speech is saying that while the economy appears to be recovering, that household debt levels are of a concern. Most consumer debt expense is through a mortgage.

In particular, the following paragraph is worthy of mention:

The simulation generates a scenario indicating that, by the middle of 2012, almost one in ten (9.6 per cent) Canadian households would have a debt-service ratio greater than 40 per cent, the threshold above which households are considered financially vulnerable (Table 2). Moreover, the percentage of debt owed by these vulnerable households would almost double. Both of these metrics are well above their recent peaks.

It is worthy to note that “Scenario 1” and “Scenario 2” of the Bank of Canada have short term interest rates at 1.5% at the end of 2010, and 3.1% at the end of 2011 (in Scenario 1) and 4.00% at the end of 2011 (in Scenario 2). These are hypothetical scenarios, but it does not appear that the Bank of Canada will be keeping rates at 0.25% past their June 2010 declaration.

A debt service ratio is generally considered to be debt interest expense divided by pre-tax income. Depending on what type of statistics one prefers to look at, household income in Canada averages roughly $86,000 for a married couple, or roughly $36,000 for an “unattached individual”. In the case of an individual, a debt coverage ratio of 40% is paying approximately $14,400 a year in interest payments, or about 1,200 a month.

Right this second, the best market rate you can get on a variable rate mortgage is prime minus 0.25%. Prime currently is 2.25%. So if you have your average unattached individual buy a condominium for $300,000, they will be paying about $6,000/year in interest payments. However, if the bank rate goes up 2.85% as it will in “Scenario 1”, suddenly that $6,000 interest payment will be going to $15,300 a year. On a $36,000 pre-tax income (or about $29,300 take-home given BC 2010 tax rates), this is a huge amount of debt service, just over half. If you use a $50,000 pre-tax income, your net take-home goes to $38,900 and interest represents 39% of after-tax income.

Half-year fiscal report card for Canada

The September update of the Fiscal Monitor is out. This is the half-year mark for fiscal reporting in Canada. We have as follows, for the first half-year comparing 2008-2009 vs. 2009-2010:

1. Personal income tax collection down 7.5%. This is slightly offset by income tax reductions (by virtue of raising the thresholds for the lower two tax brackets).

2. Corporate income tax collection down 39.5%. This is slightly offset by corporate tax reductions, but this shows that corporate profitability has fallen off a cliff between years.

3. GST collection down 17.9%. This is a good indicator of consumer spending.

4. EI Benefits paid up 50.1%. Probably the best proxy measure for unemployment – these people in the future, assuming they do not get jobs, will be paying less in personal income taxes as well.

5. Budgetary balance of a $28.6 billion deficit for the half-year. Extrapolating this out for a full year will result in a $57 billion dollar deficit for the year, slightly higher than the government’s projection of $55 billion.

Oddly enough, public debt charges (i.e. interest on debt) is down from $16.5 billion to $15.1 billion which is because of the very low interest rates offered by the Bank of Canada on public debt. As the term structure of interest rates is severely low at this point in time, it makes one wonder what will occur if or when interest rates start to rise again. Right now the Bank of Canada will happily take your money at 1.12% for 2 years. It will also take your money for 3.22% for 10 years. At this moment, the Bank of Canada should be trying to sell as much long-dated debt as they can, as they are receiving exceptionally low rates.

August 2009 Fiscal Monitor Released

The Ministry of Finance released the August 2009 Fiscal Monitor today, which is the best at-a-glance fiscal picture of Canada. I covered the July month in a previous post.

The extra month of data continues to print a grim picture – while personal income taxes in the five months between April and August have dropped about 5% (and this does not account for the fact that the government has been reducing income taxes by increasing the basic rate and also increasing the lower two income thresholds in the previous federal budget), corporate taxes continue to fall off a cliff, down 37% in the equivalent period. Only 2% of that is explained by the small decrease in the corporate tax rate between periods.

On the consumer spending side, GST collections actually increased 6% on a month-to-month basis (which is relatively surprising), but the net collections over the five month period has been down about 20%.

Unemployment insurance benefit payments, another barometer of job loss, is up 54% over the equivalent 5 month period last year.

The total fiscal deficit for the 5 month period is $23.7 billion dollars, which if extrapolated, will suggest a total deficit for the fiscal year of approximately $57 billion.

The two take-home messages of this report is that corporate profits in Canada have dropped dramatically; paradoxically, the phased in reductions in income tax that will occur over the next few years (19% to 18% effective 2010; 18% to 16.5% effective 2011; and 16.5% to 15% effective 2012) will have less of an impact and will likely cause more investment to come into the country. The other message is that personal income tax collection seems to be down slightly, but unemployment is rising, but people continue to spend. It makes one wonder how much of a pool of savings there is for people to draw on when they are not working.

Inevitably, Canada’s fiscal situation is stronger than in the USA. If Canada were running deficits equivalent to the level of the USA’s economic output, we would be on track to run a $180 billion deficit for fiscal 2010.