We’ve all heard about the impending fiscal calamity south of the border. The issue, of course, is whether lawmakers in the U.S. will increase the $14.3 trillion debt ceiling by August 2 (or thereabouts) so the U.S. can pay its bills.

That’s got many Canadians concerned about how this mess will impact interest rates north of the border.

From the looks of things, it’s not quite panic time. The odds are good that U.S. lawmakers will come to an 11^th hour agreement if you believe what yields in the $13.5 trillion dollar treasury market are telling us. The benchmark 10-year U.S. note has remained calm, barely moving in the last few weeks. Most other credible sources, including the Bank of Canada’s Mark Carney, also expect a resolution by the deadline.

That said, the outcomes at this point are completely uncertain for two reasons: 1) There’s no assurance that Republicans and Democrats will come to terms in time; and 2) a default is totally without precedent in the U.S.

TD’s chief economist Craig Alexander writes, “The impact on Canada could range from a hiccup in our base-case economic outlook, to one in which we are thrown back into a recession that could have a global reach.”

If the U.S. can’t meet its obligations on time, TD senior economist James Marple says simply: “We have no idea how bad it could be.”

Neither do we. Nonetheless, we’ve taken our best guess at two of several possibilities and their potential implications:

Possibility #1: The debt ceiling is raised on time

The good news: A crisis would likely be averted (for now). A Democrat/Republican compromise buys time for the U.S. to figure out how to stem its red ink. This predicament might even provide enough incentive to make headway towards balancing the U.S. budget (which would have a downward influence on North American interest rates long-term).

The bad news: The world has been lastingly reminded that U.S. government debt is not as “risk-free” as once thought. The rating agencies may give the U.S. a limited amount of time to put forward a credible deficit reduction plan. If it doesn’t, America’s haloed “AAA” debt rating could eventually be cut. That could shock financial markets and put us back in crisis mode. 

Potential Interest Rate Impact: A Democrat & Republican debt deal would likely entail a slashed U.S. budget. That could slow the economy and weigh down yields. Rates could be further influenced by:

1. A ratings cut:
   • If the debt ceiling plan is deemed too risky by the market, ratings agencies could cut America’s debt rating, driving up yields up in the short term. The rate spike could be severe in the short term but probably not extreme in the long term (given the liquidity of the American debt market and the U.S. dollar’s primary reserve currency status).
   • We’ve seen TV analysts speculate that the short-term impact would be a 50+ basis point spike in long-term U.S. rates.
   • U.S. yields might then settle down to roughly a 25 basis point premium over today, suggests Blackrock Analyst Rick Reider.
   • Canadian and U.S. bond yields are 95% correlated. As a result, our treasuries would likely reflect a portion of that increase (at least in the short term). That would boost fixed mortgage costs here by some fraction of a percent.
2. Budgetary progress:
   • If the U.S. eventually tabled a balanced budget, yields could drop back down (somewhat similar to how they did in Japan after its 2002 ratings cut).

 

Possibility #2: The debt ceiling is not raised in time

The good news: In simple terms, there are two types of government default: default on debt obligations and default on non-debt obligations (wages for government employees, the military, social security, etc.). The most crucial priority in the short-term is making principal and interest payments to holders of U.S. treasuries. Fortunately, the U.S. can still pay bondholders for a period of time. That means an actual “debt default” would likely be averted, hopefully long enough to permit a resolution.
 

The bad news: As the U.S. Treasury states, an impasse after Aug. 2 would merely be “default by another name.” The U.S. would undergo a severe fiscal shock with most of the government shutting down. America’s debt rating might very well be cut, thus driving up yields (and hence fixed mortgage rates). Canada’s economic outlook could be downgraded as well since we’re such a huge trade partner with the Americans.

Potential Interest Rate Impact:

• Long-term U.S. rates would soar in the short-term.
• Canadian rates could follow in sympathy, but to what degree is unknown. (Longer-term bonds lead fixed mortgage rates)
• To battle the economic contagion, the Bank of Canada would leave our overnight rate lower than it otherwise would. That would likely keep variable mortgage rates low.
• In the short to medium term, default could spark a rocketing loonie (versus the U.S.) and put the brakes on the Canadian/global economy. That would exert downward pressure on rates over time.
• Canadian rates might also be helped by asset rotation out of U.S. treasuries and into Canadian bonds. As more people buy Canadian bonds it lifts bond prices and lowers yields (and fixed mortgage rates).

*******

If another economic crisis does ensue, the odds favour variable mortgage rates over longer-term fixed rates.

If you’re a homeowner or prospective mortgagor who is concerned by all this, the best bet is to wait until next week and see how things play out. Then speak with a mortgage professional.

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Rob McLister, CMT