Interest Rates 4: Denials and Delusions

Seems the last few posts on interest rates have touched a nerve.

The inbox overflows with 'viewer mail', and a lot of it takes issue with the idea that interest rates will be going up or that rising interest rates will have an impact on housing prices.

Where to begin?

One reader makes the passionate case that our economy is in a similar state to the post-1929 era. As recovery stalled, interest rates remained low for years. As we can see by this graph, rates were at low levels from the early 1930s until 1957 (click image to enlarge):

Won't our government keep rates low now to prevent a catastrophic collapse of the economy and the real estate industry?

Others make similar arguments centered around the belief that the Bank of Canada (or a Conservative or Liberal government) won't ever allow interest rates to rise because of the harm it would do to the economy.

Nice sentiment. The problem is... the Bank of Canada or the Prime Minister won't have a say in the issue.

For the past 10 years, the Bank of Canada (and other western central banks) have been able to 'stimulate' the economy by lowering their own central rates. But we now face a looming crisis that cannot be controlled by manipulating by the central bank rate: the crisis of debt.

The latest forecast by Dale Orr Economic Insight realistically concludes the Canadian Federal Government is about to add $160 billion to the national debt. That means Canada’s debt will soar to $620 billion within seven years. The deficit this year alone will be between $47 billion and $50 billion.

To properly appreciate what this will do to interest rates, we must understand how our nation funds it's debt.

Coincidently, Garth Turner just wrote about this last night. I defer to his excellent summary:

• Every second Tuesday the Bank of Canada auctions off hundreds of millions of dollars in T-bills. Every four weeks, about 40 investment dealers on an approved list (dominated by the Big Six) go to auction to place bids on Government of Canada long-term bonds (any bond with a maturity of 10 years of longer). Those auctions are worth hundreds of millions. The money then flows into the central bank’s general revenue account, where it is made available to the federal government to spend on stuff we can’t pay for. Each new bond issue is added to the national debt.
  
  The investment dealers buy those bonds which are then sold to institutional and retail investors who purchase them for yield – an income stream. And every bond issue must compete with debt being issue by Ford Credit Corporation, Research in Motion, Google or other corporate issuers. The bonds also have to compete with US Treasuries and Eurobonds – and lots of other governments which are trying to flog their debt in order to stave off fiscal disaster.
  
  Of course, Canada also issues bonds in the US, known as Yankee Bonds, in Japan (Samurai bonds), on the Eurobond market and elsewhere. And right across the world, the need for capital is growing by leaps and bounds – as Canada joins a long list of countries who are utterly unable to corral their spending in a time of recession. JMK would be so proud.
  
  But here’s the rub: Money used to buy new bond issues cannot be created by government. It has to come from savings – capital already in existence, the result of individuals’ labour, corporate profits and economic activity. That means as the demand for money inexorably explodes over the next few years, the price of it will also rise. Global competition will see to that.
  
  And suddenly the Ontario Teachers’ Pension Fund and the BC Municipal Pension Plan will be demanding higher returns for the debt they hold, which Nesbitt Burns, Wood Gundy and Dominion Securities will seek out on their behalf. As interest rates start to rise, bond prices will fall and yields will increase as existing bonds trade at a discount to their face value.
  
  Higher yields in the bond market (which is 14 times larger than the TSE S&P) translate within days – sometimes hours – into higher mortgage rates for consumers, and this happens whether or not the Bank of Canada has moved its overnight loan rate.

That's why rising interest rates are inevitable. It will be the only way America, the U.K., Canada et al can procure the necessary funds to finance their burgeoning debt levels. And it will all happen whether the Bank of Canada or the Federal Government wants it to or not.

More significantly it won't be a 2-3 year phase either. Increased rates of 8% - 12% (or higher) will be with us for more than a decade, thus affecting all Canadians whether they currently have one year variable or 5 year fixed term mortgages.

That's why the governor of the Bank of Canada recently warned Canadians that "the age of ultra-low interest rates will be ending soon," and that "Canadians should prepare for more normal rate levels."

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Email: village_whisperer@live.ca
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