Think the feds won't let rates rise?
Read this.

OK, class, drop the iPhones, the oxys and the Hanna Montana banana guards and pay attention. This blog’s now in session.

Over the summer some of you have posted inane stuff. Maybe it was a cry for attention. Maybe hormones. Maybe just misguided. But it was lame. Especially when it comes to the oft-repeated argument that cheap interest rates will save the sorry and exposed butts of many recent homebuyers.

Like this from some cowboy: “Interesting posts from your readers about seeing higher mortgage interest rates ahead. One problem: The Bank of Canada wants people to borrow – if they increase rates, people are less likely to buy homes. Higher interest rates lead to decrease in values, but still make it harder to buy. Some have written that the Chinese could call in their loans creating catastrophy. This is unlikely to happen.”

Yeah, right. So let’s dig into this a little.

As you should know, a hike in mortgage rates to the historic average of the last 20 years, about 8.25%, would have a big impact on millions of people. For example, a cheapo Van house worth $600,000 bought with 10% down can be financed now with a VRM at 3% for $2,560 a month, requiring an income $92,000. But if it renews in, say, 2014 at 8%, payments jump to $4,200, needing an income of $151,200.

And, guess what? The average family income in Canada is still under $65,000 – stuck where it’s been for the past decade or so. And I haven’t even factored in the double land transfer tax to be financed in Toronto or the HST to be added onto real estate transactions in BC and Ontario. (Or 1.5 million people without jobs.)

In short, interest rates at normal levels would nuke affordability and return us to those forgotten times when people bought houses with large downpayments so they could have small mortgages. How quaint.

So, the argument goes, this is exactly why the BoC will never raise rates and end the party. I mean, really, why would that happen? People who bought with little or nothing down will have… little or nothing. Tens of thousands of couples (or multiples thereof) will realize they might not qualify to renew mortgages on homes they already own. Others will sink into negative equity, owing more than their homes are worth, as higher rates drop house prices from their current all-time highs.

Why would the government let that happen? Haven’t those dudes heard about granite, stainless and Debbie Travis?

The reality is, Canada’s central bank is as powerless as that of, say, Iceland, to prevent, moderate or withstand changes in the price of money. Part of this is because we have a floating currency, which we need to stabilize. Partly it’s due to our total dependence on trade in a globalized economy and the now de rigeur coordination of central bank policy among nations.

But mostly it’s about debt.

The latest forecast by Dale Orr Economic Insight realistically concludes the feds are about to add $160 billion to the national debt. That means after dipping into the $400 billion range, Canada’s mortgage will soar to $620 billion within seven years. This will happen because federal finances have fallen off a cliff, and the deficit this year alone will be between $47 billion and $50 billion. This is the worst ever. Beats the hell out of Mulroney by about ten bill.

So what?

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So, where does that money come from? After all, $620 billion is half the entire economy. It doesn’t just fall out of an ATM at Sobey’s. And tax increases, it seems, are out of the question since they’d only shove the economy back into the deflationary funnel we’ve tried to escape.

So, where does the cash originate?

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 or 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. Then the central bank can use all the tricks it has to moderate rates, like drawdowns and Specials, but to little avail.

Up she goes.

Class is like so dismissed.