Canadian real estate prices are rising at rates even the banks are warning about. There’s a lot of reasons this is happening, but one rarely discussed is the supersized borrowing from the Government of Canada (GoC). A lot of cash was needed during the pandemic, but Canada’s discretionary spending topped the G20. To help facilitate this spending, the Bank of Canada (BoC) made use of quantitative ease (QE). The unconventional policy tool’s use is debated, but its impact is well established.
Keeping rates artificially low causes distortions in other areas of the economy. The longer and large the use of the program, the more distorted markets become. In an economy twice as dependent on real estate as the US during its housing bubble, you can guess where it landed. Let’s talk about government spending, QE, and how it made buying a home even more difficult.
Government Debt and Quantitative Ease (QE)
Quantitative ease (QE) is a policy tool where central banks buy government bonds. The goal is to increase demand enough to raise government bond prices. By increasing bond prices, the rate paid to new bondholders (yield) falls. Since credit markets compete for similar capital, borrowing costs drop across the market.
Credit markets are subject to the laws of supply and demand, like most markets. If the GoC needs more credit than borrowers will readily lend, yields need to rise. In a QE environment, the BoC aggressively buys bonds to lower borrowing costs. The more a government needs, or the longer it does, the more QE usually needs to be used. The longer QE is used to create artificially low rates, the longer they distort markets.
To the average person, the government borrowing at low rates seems like a great thing. Taxpayers pay less in interest, right? The problem is there’s more to life than what the government pays for. By distorting borrowing rates, everything from pensions to home prices becomes distorted. One fund manager that deals with pensions called it “financial vandalism.” Trading in a pension, or paying 50% more for a home, may not be such a great deal for those corporate handouts… to some, anyway.
Quantitative Ease and Mortgage Rates
I can go on forever about market distortions from QE, but one of the biggest ones is mortgage credit. The GoC 5-year bonds directly influence the cost of 5-year fixed mortgages. Since lenders try to fund for as low as possible to make up on volume, they drop to compete with the GoC. Mortgage lenders typically pay a small premium on the GoC bond rate, as a slight “risk” premium.
If GoC rates fall, fixed mortgage rates for comparable time periods fall. Lower mortgage rates increase the amount of debt a borrower can take on. Increased budgets allow a borrower to more easily absorb higher home prices in a hot market. After all, if you don’t have the money — you don’t have the money. Prices can only rise as much as budgets will allow. If everyone has more money, well — buyers can compete to see who gives it to the seller.
It’s key to understand this isn’t just a low interest rate problem either. It’s beyond that. Low interest rates increase budgets. QE makes interest rates artificially lower than the market would naturally support. This makes budgets larger than the market can naturally support, causing huge distortions. Large and persistent QE can make home prices rise faster than possible in any normal market.
The other day on Twitter, a politician and investment banker both said I was wrong about QE and mortgages. Rather than debating the issue with them, like it’s a big mystery, let’s check in with the Bank of Canada. Here’s what they say:
Government bond yields have a big influence on other borrowing rates. Lower yields make it cheaper to borrow money. So, QE encourages households and businesses to borrow, spend and invest. For example:
1. We can buy five-year government bonds, which will lower their yield. This would be reflected in lower interest rates on five-year fixed-rate mortgages, making it cheaper to borrow to buy a house.
Glad we cleared that up.
The Bank of Canada Bought 95% of Canada’s New Government Debt Issuance
Just how big was this QE program, anyway? The BoC now holds $360.8 billion in GoC bonds as of April 14, 2021. National Bank of Canada (NBC) determined, as of April 9th, the BoC held about 40% of the GoC total outstanding bonds. The bank said, “it’s taken just one year to radically transform GoC bond ownership.”
Bank of Canada Ownership of Government BondsThe dollar value of Government of Canada bonds the Bank of Canada has on its balance sheet. Source: BoC; Better Dwelling.
Prior to the pandemic, NBC says the BoC held much less. Their analysis found the BoC held a relatively stable 13% of bonds issued in the past. They also found the BoC bought the equivalent of 95% of new issuance between March 2020 and March 2021. The bank said this is, “an absorption rate that’s really hard to overemphasize.” It’s also hard not to distort the market when you need to make a supersized budget affordable.
Bank of Canada Expected To Taper QE Buying
The BoC is expected to announce a tapering of QE this week, but that depends on how much debt is needed. Currently, the BoC is buying $4 billion of GoC bonds per week to help keep rates affordable. It’s expected they’ll drop it to $3 billion per week soon, with the economy doing better than they had forecast. Even with the taper, NBC is forecasting the BoC will own 45% of GoC bonds by year-end. That’s a lot of rate suppression and artificially low rates to still come.
BoC deputy governor Beaudry argues, “we are not providing a free lunch for the government through QE. The government will have to repay the bonds that we purchase.” However, he recklessly fails to acknowledge artificially low rates are a free lunch. By supporting lower than market rates, the government can borrow much more than usual. Ditto with homebuyers. While that’s a discount for the government, it comes at a cost of distortion to everyone else.
Is the government financing debt for corporate handouts worth paying much for a home? How about retiring with less cash in your pension? I have no idea what that means to you, but I know how I feel. I’m okay with QE being used for necessary spending gaps. However, I do think a low amount of scrutiny leads to its toxic overuse. The issue goes far beyond whether tax revenues can support the payments.
Regardless of whether the spending is justified, or some of it frivolous waste, the point is QE exists. A lot of it. The artificially low rates spill beyond government spending, into other areas like housing. That’s great for the government and people refinancing, but not so much for buyers in a hot market. QE pulls forward demand and allows prices to grow faster than they naturally could.
Artificially low interest rates are great for the government but lead to market distortions. The larger and longer the use of QE, the worse the resulting inefficiencies. Especially if most of the credit growth is in a single area like residential mortgages. As QE tapers, the segments that saw distortion also tend to correct to bring them back to natural levels. However, sometimes markets are pushed to such inefficiency it will take decades to fix.
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