February 5, 2014

Why Canadians Should Care About The U.S. Taper

Penelope Graham
RateSupermarket.ca

Have you caught a glimpse of the latest financial headlines? If so, you’ve probably heard the latest buzzword spouted by economic pundits – the “great tapering”. The media has hyped this economic policy measure nonstop for months, and hysteria has been growing over what it means for the economy – in the U.S., in Canada, and around the world.

But if you’re not a foreign monetary policy expert (and let’s face it – who has the time?), you’ve likely been asking – what the heck is the taper? And why should I, as a Canadian, care about changes to the U.S. economy?

The truth is that whatever the U.S. does has a ripple effect around the globe – and especially for the Canadian cost of borrowing. This means that the taper could have a direct effect on what you’ll pay – for your mortgage, for your loans, even your consumer goods.

Here’s what you need to know about the taper – and how it will ultimately impact Canadian interest rates.

 

Monetary Policy 101

So… what exactly is the taper? In econ speak, it’s the scaleback of the extraordinary quantitative easing measures implemented by the U.S. Federal Reserve during recession recovery. Translation: In order to stoke the economy after the financial crisis, U.S. policy makers pulled some strings to keep the cost of borrowing low and consumer spending up.

 

How they’ve done this is two fold:

One, they’ve kept their central interest rate, which decides the price of lending for banks, at a record low 0.25 per cent. This keeps the cost of variable borrowing low, because banks pass the discount down to customers. (Canada has taken a similar approach, keeping our interest rate at one per cent since September 2010.)

Two, they have been buying back mass quantities of their own national bonds each month. This keeps those bond yields low, which keeps the cost of fixed borrowing (aka mortgage rates) low.

But these special circumstances can’t last forever. Economists have long warned that such low interest rates simply aren’t sustainable. So, now that things are looking up econ-wise (stronger job numbers, growing trade and a rebounding housing market), U.S. policy makers have started the process of “tapering” their $85-billion-per-month bond purchases. The first round happened in December, to $75 billion. This past Wednesday the second round cut bond buying to $65 billion a month.

 

The Bond Breakdown

Scaling back these bond buys is a very delicate process – not only does the U.S. need to avoid shocking its own economy with higher rates, but the health of the global economy also rests on the nation’s shoulders.

This is due to the nature of these bought-back bonds.

Bonds are an investment type that locks in the original investment amount (the principal), for a set term, and pays that back to the investor plus additional interest at maturity, known as a coupon or yield. The general rule of thumb is that the riskier the bond, the higher the yield, as investors must be persuaded to take on the risk. This is why bonds from embattled countries like Spain and Portugal have very high yields, while in the U.S. and Canada, they are very low.

Bonds are also very sensitive to supply and demand – when fewer investors buy them, they become higher risk, their prices drop, and their yields rise. For investors already owning bonds, this is bad news – in order to trade or cash in their bonds, they must now do so at a discount and take a loss. The U.S. ceasing their bond buying means lower demand – and investors are worried about their bond values.

 

The International Fallout

Investors have not been taking the tapering news well. Last July, (now former) Fed Chairman Ben Bernanke just mentioned the possibility of tapering… and markets collectively spazzed as a result. Investors dumped their bonds and yields shot sky high. Keep in mind that this happened to Canadian bonds too. As a result, fixed mortgage rates spiked from the record lows home buyers had enjoyed all spring.

Now, two rounds in, it’s still a perilous process. The latest cut on Wednesday has created a struggle for emerging markets – as the U.S. Dollar gets stronger, their currencies have weakened and investors have started dropping their stocks.

This currency slide happened in Canada, too – our Loonie has dropped to 89.65 cents USD. Unlike these smaller countries, however, Canada can hold its own – a weaker dollar may actually mean good news for our trade industry, and boost our own flagging inflation levels, and that could make our own interest rates – and variable mortgage rates – rise.

 

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Penelope Graham is the Editor of RateSupermarket.ca’s Money Wise, the personal finance resource that “Makes sense of it all”. In addition to providing a daily breakdown of current economic news for everyday Canadians, Graham has also provided commentary to publications such as the Globe and Mail, The Toronto Star, and MSN Money.

Read more, and find your best rate, at RateSupermarket.ca, Canada’s comprehensive and transparent personal finance resource.

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