In a sign of things to come, a seemingly innocuous sentence fragment from new Fed chair Janet Yellen, "six months, something like that," caused a mammoth flinch throughout global asset markets. Gold and U.S. bond prices plummeted almost before she had finished the sentence, and the S&P 500 shed almost 1 per cent in five minutes.
Ms. Yellen's comment was a response to a question regarding the time lag between the end of the Fed tapering its stimulus and its tightening interest rates. That time frame would put a Fed rate hike in the first half of 2015 – at least two quarters earlier than markets expected.
For Canadians, this makes Ms. Yellen the leading candidate for pricking the Canadian housing bubble.
The chart this week shows that even if the Canadian and U.S. economies are moving in different directions, Canadian yields track U.S. yields very closely. Over the past decade, Canadian five-year bonds traded with yields only 16 basis points away from U.S. Treasuries, on average.
When U.S. rates rise, government of Canada bond yields climb with them, whether this makes sense based on the domestic economic backdrop or not.
Mortgage rates follow five-year bond yields. So, as the expected Fed rate hike approaches, markets will begin pricing in a chain reaction – U.S. bonds yields will rise, causing Canadian five-year bond yields to climb, and this will result in higher Canadian mortgage rates.
The futures market currently predicts that LIBOR – the interbank lending rate that serves as the benchmark for global fixed-income markets – will climb by about 50 basis points by September 2015. The Canadian five-year bond yield may not rise as much, but Canadians can expect five-year mortgages to rise by at least 25 basis points.
A small increase in the mortgage rate could have an outsized effect on the housing market because it chips away at affordability at a time when home prices are already stratospheric relative to income and many Canadians are deep in debt.
To a significant degree, the Fed helped drive the Canadian housing boom – so, it's only fitting that Ms. Yellen is the architect of a downturn. From the U.S., Canada imported lower rates than the economy warranted after the financial crisis, and this increased demand for housing.
The flip side of that coin will be apparent as rates rise south of the border.