Using high leverage–borrowing to ‘invest’ or spend–is like driving 200 miles an hour everywhere that you go. So long as weather is perfect, there are no turns, no judgement or mechanical problems, and nothing ever comes into your path, you will undoubtedly get to your destination faster. But as soon as anything does occur, you have a huge probability of wiping out yourself and your surroundings. After 9 years of record leveraging, a recent report from MacQuarie Capital Markets reminds of a timeless truth now haunting many countries, and Canada in particular. See: Hyper-leveraging risks Bank of Canada policy error:”
The unprecedented rise in consumer debt means the Bank of Canada’s rate-hiking cycle is already the most severe in 20 years and further increases will have far graver consequences than conventional analysis shows, Macquarie Capital Markets Canada Ltd. said.
Assuming just one further rate rise, the impact would be 65 percent to 80 percent as severe as the 1987 to 1990 cycle, according to Macquarie, which took into account five-year bond yields, household debt and home buying. Canada’s housing market slumped in the early 1990s after that rate-hike cycle and a recession.
Although a distinction I would make here: the policy error that has been replicated by central banks around the world, is not increasing rates off the zero bound over the past year, but rather, the error was in leaving rates near zero for the unprecedented 8 years before that. It was this madness that encouraged and enabled the self-destructive financial decisions now ailing us.
It is necessary to try and raise policy rates as well as lending standards from what has been years of recklessly low levels–although there is little room to continue much further this cycle, before the slowing economy prompts cries for cuts and easing (!) again. In the meantime though, asset prices that have been ramped up unreasonably on rising leverage, will come back down to reconnect carrying costs with free cash flow. Falling asset prices will also compound problems for those needing to refinance or sell into strength.
For real life examples of household financial stress already in motion, watch ‘Digging out of debt, real life scenarios’ with Canadian trustee in bankruptcy Scott Terrio.