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Canadian Bond Yields & Mortgage Rates After U.S. Downgrade

US-debt-downgradeBenjamin Franklin and the founding fathers wouldn’t be proud.

On Friday, the previously unthinkable happened:  The United States lost its AAA S&P debt rating for the first time in history.

This cut, while somewhat debatable, somewhat telegraphed and largely symbolic, will panic some investors and likely spark knee-jerk selling of stocks and longer-term U.S. bonds on Monday.

We’ll take a stab at what it could mean for Canadian mortgage rates…

Thumb-nail analysis:  Once everything shakes out, analysts suggest that this U.S. rating cut will have more of a downside influence on Canadian interest rates than upside influence.

Extended analysis:  S&P’s downgrade could prompt a series of short- and long-term effects. Here’s a take on those…


Short-term Effects

Financial Market Road SignYield Volatility: “(U.S.) bond prices will go down," says fixed income commentator Laura LaRosa (ostensibly due to selling from panicked investors and a small amount of forced liquidation by funds that can only hold AAA investments). That said, forced selling will be limited since the U.S. is still considered AAA based on an average of the top 3 rating agencies. Simultaneously, U.S. bonds may see buying from investors who are:

  • fleeing riskier securities (like stocks & European securities)
  • bearish on the U.S. economy
  • optimistic that this downgrade will move the U.S. to fix its deficit.

Yes, as unintuitive as that seems, there is still no investment as liquid (and few as safe) as U.S. treasuries. That said, it's impossible to say how much this buying will offset the reactionary selling. There is also some debate on the credibility of this downgrade. “There is no justifiable rationale for downgrading the debt of the United States," says Treasury official John Bellows. Moreover, S&P made a “slight” $2 trillion boo boo in its initial downgrade analysis. The net effect is that this is not a positive development short-term. U.S. long-term yields could shoot up 25-70 basis points in coming months according to some analysts (more).

Canadian-Bond-BuyingCanadian Bond Buying: Canada is one of just 18 countries left with a AAA rating, and the only one in the Western Hemisphere. It also has a budget that’s reasonably under control. Both of these points will attract U.S. Treasury investors seeking a new home to park their billions. The one question mark is whether investors will prefer bonds from countries less leveraged to commodities (lower commodity demand hurts our dollar, which makes Canadian bonds somewhat more risky to foreign buyers). On the other hand, a potential U.S. economic slowdown will calm inflation fears. That could counteract selling and push down Canadian yields. Since mortgages are linked to bonds, it’s not unthinkable that 5-year fixed mortgages could move lower before long.

Long-term Effects

Economic-RisksEconomic Risk:  The downgrade’s impact will be cushioned because it "pales in significance with evidence of flagging economic growth," notes Reuters. If America’s economy weakens materially as a result of falling U.S. confidence and budget cuts, yields could drift lower. Despite Japan losing its AAA rating in 1998, its 10-year bond is down to ~1% today! (The U.S. 10-year bond closed Friday at 2.56%). Being 95% correlated to U.S. Treasuries, this implies Canadian bond yields could also drop long-term. "We are a trading nation, with about a third of output generated by exports and deep linkages with the U.S. economy,” said Finance Minister Jim Flaherty. This implies mortgage rates could remain low as time goes on.

Bond-Rating-AgenciesRisk of Another Downgrade: S&P has assigned a “negative outlook” on the United States. It may cut America’s rating again within 6-24 months if lawmakers don’t slash the deficit or if rates rise significantly. Another downgrade would certainly be preceded or accompanied by downgrades from Moody’s and Fitch. That might be a game changer. If United States’ debt rating was cut by a second agency, it would have far more profound effects than S&P’s cut on Friday (because of wider selling of Treasuries and the corollary effects). While far from a perfect analogy (due to market size, debt holdings and economic reasons), the chart below shows what happened to yields in Japan after three rating agencies demoted its debt in November 1998.


Most believe a U.S. yield spike would be less pronounced than Japan's if a 2nd rating agency cut the U.S. from AAA to AA+. Below, for example, is what happened to Canadian yields after our debt rating was cut in April 1993.


The primary implication for Canada in all of this is a drop in our economic output resulting from multiple U.S. downgrades. Other things being equal, the lower our output, the lower inflation and the lower our long-term mortgage rates.

US-Dollar-WeakDiminished Reserve Currency Status: Foreign governments will be less likely to hold U.S. dollars in reserve if America’s creditworthiness is in question. Barclays says this could boost U.S. interest rates by another 25 bps. Meanwhile, Canadian bonds (and the Loonie) could benefit long-term for the opposite reasons.

Blessing in Disguise: U.S. spending is simply unsustainable. The whole world knows it. China, America’s biggest creditor, is demanding the U.S. slash its “gigantic military expenditure and bloated social welfare costs.” U.S. yields could eventually fall if Congress uses this wake-up call to trim spending. Canada lost its AAA rating in 1993 but got it back nine years later after cutting programs and balancing its budget. Conservatives will certainly use this U.S. downgrade as justification to keep our own budget in check. That again should be good for Canadian interest rates.


Bottom-line for Canadian Mortgage Rates

The above implications all seem to favour variable rates over the next five years. Canada’s economic ship will likely be anchored by a weakening U.S. economy, lessening the upside risk for our own prime rate.

Source of Japanese & Canadian 10-year yield charts:

Rob McLister, CMT