BUSINESS

The interest rate jolt

Central bankers trigger a sudden panic among home buyers with an abrupt increase in rates

JOHN DALY April 4 1994
BUSINESS

The interest rate jolt

Central bankers trigger a sudden panic among home buyers with an abrupt increase in rates

JOHN DALY April 4 1994

The interest rate jolt

BUSINESS

Central bankers trigger a sudden panic among home buyers with an abrupt increase in rates

JOHN DALY

It is a long way from the solid stone headquarters of the U.S. Federal Reserve Board in Washington to Re/Max real estate agent Barrie Ibsen’s office in the basement of his house in southwest Calgary. But like most realtors, Ibsen knows that decisions made by American central bankers usually have an almost immediate impact in Canada. Even before federal reserve chairman Alan Greenspan announced last week that the board had decided to “increase slightly” the “upward pressure” on interest rates,

Ibsen was warning his clients that a jump in American rates was imminent, and that Canadian rates would soon follow. The day before the announcement, Ibsen convinced 25 of them to sign pre-approved mortgages that guarantee a five-year rate of 7.25 per cent if they buy a house within the next 90 days. Once Greenspan’s announcement came, the reaction was swift. The Bank of Canada raised its trendsetting rate by 0.78 percentage points to 5.0 per cent, prompting most banks and trust companies to increase their mortgage rates by up to a full point. In Calgary, and across the country, anxious house hunters deluged realtors with phone calls. “There’s a real fear factor,” said Ibsen. “People are saying, ‘Rates are going up, we have to buy now.’ ”

That fear factor spread far beyond the housing market, triggering wild swings on currency and stock markets.

But despite the size of the jump in rates—and the sharp fluctuations in financial markets—experts remained divided on how long the higher rates will last. Both in Canada and the United States, central bankers appear to be reacting to shortterm trends. In Washington, Greenspan had been consistently warning for several months that strong U.S. economic growth might rekindle inflation. By nudging most American rates up by a quarter of a percentage point last week, Greenspan was demonstrating his resolve to contain inflation. But the U.S. inflation rate has actually declined to 2.4 per cent from three per cent over the past

year, and few forecasters expect it to rise soon. And Canada’s inflation rate—even excluding the impact of controversial tobacco tax cuts last month—is holding at under two per cent. However, Greenspan’s rate increase, coupled with a steady sell-off of Canadian dollars on international currency markets by speculators over the past month,

7.25% 8.95%

$715.92 $824.70

per month per month

Payment variance

$108.78 per month

forced Bank of Canada governor Gordon Thiessen to raise rates or risk further declines in the value of the dollar.

For home buyers—and homeowners renewing their mortgages—the jump in the bank rate meant they had only a short time to lock into mortgages at the lower levels before the major chartered banks and other lenders followed the Bank of Canada’s lead and hiked their rates. After hesitating briefly, the banks and trust companies raised their bellwether five-year mortgage rate by a full

point to 8.95 per cent, and increased other loan and deposit rates. Some prospective home buyers got in just under the wire. Sharon Smith, a real estate agent for Royal LePage Ltd. in Barrie, Ont., 90 km north of Toronto, said she hurriedly delivered three just-completed applications to a local mortgage broker at his home minutes before midnight on March 24, the day before rates shot up. Said Smith: “This certainly has created a lot of excitement.”

In other cities across the country, the panic was almost palpable. “People are in a frenzy out there,” said Omer Quenneville, a sales representative with NRS Solid Choice Realty Inc. in Toronto. Quenneville said that last week eight of his clients put in offers for homes that were actually higher than the seller’s asking price—something that has not happened since the heady days of the Toronto real estate boom of the mid1980s. Quenneville said he tried to calm eager buyers by assuring them that the sudden surge in real estate demand will result in more homes coming onto the market and pushing down prices. But many were not listening. “I just put a sign up in front of a house this morning,” he said on the day mortgage rates jumped. “I’ve already had seven calls.” The interest rate increases also 2 jolted international currency markets. I Thiessen raised the bank rate to defend § the Canadian dollar, which had declined by more than three cents against the I American dollar since January. “He’s fir05 ing a shot across the bow of the specie ulators,” said Michael McCracken, I president of Informetrica Ltd., a private Ottawa-based economic forecasting agency. And initially, that shot appeared to work. The day after the rate increase, the dollar climbed by 0.14 cents to close at 73.3 cents. The Toronto Stock Exchange (TSE) 300 Index also jumped by 58 points that day to close at a record 4,609.9 points. Normally, share values decline in response to interest rate hikes, as investors shift money from stocks to interest-bearing investments that bear higher returns.

But the upsurge in the markets was shortlived. Over the next two days, the dollar

WHAT A DIFFERENCE A MONTH MAKES

The difference in monthly payments on a $100,000 mortgage for a fixed five-year term amortized over 25 years:

MARCH 1 LAST WEEK

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plunged by 0.63 cents to close the week at 72.67 cents. Stock prices followed suit. The TSE 300 fell by 81.6 points, to close the week at 4,528.3 points. In New York City, the Dow Jones Industrial Average fell by 94.7 points to close the week at 3,774.7.

In both Canada and the United States, the rate hikes rattled speculators and investors who were getting increasingly nervous about a host of other economic and political developments— some of them far removed from financial markets. The list included the assassination of Mexican presidential candidate Luis Donaldo Colosio, President Bill Clinton’s continuing problems with the Whitewater scandal and even speculation that Russian President Boris Yeltsin is in failing health.

In Canada, still other factors added to the downward pressure on the dollar and stock values; a downgrade of the federal government’s foreign currency-denominated bonds by the Toronto-based Dominion Bond Rating Service Ltd.; the Ontario government’s announcement that it may miss its deficit target this year by as much as $2 billion; and worries about the outcome of the impending Quebec election. Thiessen, testifying before the Senate banking committee in Ottawa the day after he increased rates, summed up the state of the markets in the understated language typical of central bankers. “There’s a lot of uncertainty out there,” he said. But he added: “Frequently, when markets are going through a negative period, they look for negative news to somehow justify what has happened.”

Bank of Canada, Statistics Canada, U.S. Congressional Budget Office

Despite Thiessen’s carefully chosen words, his testimony may have added to that uncertainty.

He argued that “the fundamentals are good,” noting that inflation in Canada is running below that in the United States. If that difference persists, Thiessen said Canada may eventually end up with lower interest rates than the United States. But Conservative Senator David Angus went after Thiessen, arguing that the lack of deep spending cuts in Finance Minister Paul Martin’s Feb. 22 budget showed that Martin was not serious about cutting the deficit. Thiessen agreed that deficits are worrisome, but he carefully avoided criticizing Martin. “It’s true that the fiscal situation has been difficult to get under control and it’s understandable that markets are nervous,” Thiessen said. But he added cautiously: “Can we blame all this on the budget? I’d be disinclined to agree with that.”

To many bond and currency traders, those

remarks were a red flag. Michael Hart, vicepresident of trading at the Friedberg Mercantile Group in Toronto, said that massive provincial and federal budget deficits are just as big a concern among international investors as Canada’s inflation rate. And no matter how low inflation is, Hart said, any indication from Thiessen that he is prepared to tolerate high deficits is bound to spook traders. “Markets trade on expectations a lot more than people think,” Hart said. As a result, he and many other analysts predicted that Thiessen will have to increase the bank rate even more this week to slow the dollar’s decline.

In the United States, economists and financial analysts also debated the merits of Greenspan’s rate hike. Many applauded the federal reserve chairman for demonstrating

his readiness to forestall inflationary pressures in a measured fashion without halting growth. Russell Sheldon, an economist with the Mellon Bank in Pittsburgh, described the federal reserve’s action as being like that of a motorist who “takes the foot off the gas rather than putting on the brakes.” But Sheldon also conceded that inflation so far this year has been modest, and that there are signs that the growth of the U.S. economy has moderated from its hectic annualized rate of 7.5 per cent in the fourth quarter of last year. Still, he

claimed that underlying pressures towards rapid expansion and inflation may have be masked by the slowdown effects of wicked winter weather and the Los Angeles earthquake in January.

Other American analysts argued that those fears of inflation are unfounded, and that Greenspan’s rate hike could slow or choke off the recovery. The Washington Post, in an editorial, complained that “the spectre of inflation is currently governing the speed at which the economy can grow.” But Clinton tried to put the best possible political spin on the increase. During a shouted exchange with reporters late last week while on a morning jog, he insisted that “there’s good growth with no inflation.” He added: “The economy’s on the rise, you bet it is.”

However, given the decline of the Canadian dollar on currency markets even after the bank rate jump, the only thing many Canadian consumers were betting on is another increase in mortgage rates this week. The advice from most real estate agents was predictable. As they do whenever rates jump or decline sharply, many realtors urged house hunters to buy now. “I think people recognize that this is a good opportunity to purchase property,” said Frank Loncaric, vicepresident and regional manager for western and central Ontario for Royal LePage. Loncaric added that even if last week’s increase proves to be short-lived, “rates are pretty good right now, so why wait a year?” Other agents were even more insistent. “We’ll have another full point by September,” said Re/Max’s Ibsen. “People should buy as quickly as possible.”

Many bankers, however, were more restrained. “Our economic forecasts show that this is a spike,” said Norman MacLeod, community banking manager for four downtown Toronto branches of the Bank of Montreal. He said homeowners whose mortgages are up for renewal and can afford to take a chance should consider taking out a six-month variable rate mortgage rather than locking into the new higher five-year rates announced last week. He said rates may head back down again in the next few months.

Other analysts even further removed from the turmoil that prevailed on real estate markets last week agreed that the panic is bound to subside. Informetrica’s McCracken argued that so long as inflation rates remain low and stable in Canada and the United States, there is absolutely no foreseeable reason why rates should continue to rise. His advice to prospective home buyers? “Relax,” McCracken said. ‘Take a Valium.”

JOHN DALY with LUKE FISHER in Ottawa and CARL MOLLINS in Washington

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