Juggling Dynamite

Bond analyst Alf Pecatiello warns that over the last 3 months, US bond markets have been in an aggressive and prolonged period of bear steepening of the yield curve. History shows if left unchecked, this steepening is likely to cause serious damage to equity markets and the economy. Here is a direct video link.

As shown below, since 1985 (courtesy of Game of Trades), a re-steepening yield curve has historically hammered stocks (S&P 500 in orange), especially when starting from above-average valuation periods, like in 2022, 2007 and 2000.

In its 2023 Financial System Review, The Bank of Canada notes growing concern about the ability of households to service their debt, with mortgage holders facing payment increases of up to 40%. Compounding the issue is the fact house prices are falling and reducing the amount of equity owners have:

Higher interest rates have also contributed to declines in house prices across most regions of Canada over the past year (Chart 10). For households that purchased homes near the peak in prices and made smaller down payments, this decline could result in limited or negative equity in their home. Lower home equity limits a household’s ability to refinance and extend their amortization period to reduce their monthly payment.

The Bank notes that one-third of mortgages have already experienced payment increases since 2022. And, by 2026, all Canadian mortgage holders will feel the burn, with the largest shock hitting those whose previous term was taken out during the ultra-low rate (and bubble price) era of 2020-2022. The chart below shows the percent of mortgages by type and year due for renewal.

By kicking the can and letting variable-rate customers make fixed payments that do not cover the interest costs of their loans, four of the Big Six Canadian banks now have more than 23% of their mortgages with amortization greater than 30 years.

Of the Big Six, National Bank has a more conservative book, with two-thirds of its mortgages in fixed rate terms. Even then, as noted by CEO Laurent Ferreira last month, about 85% of its mortgage customers will face “a harsh new reality” when they need to renew those loans in 2024 through 2026. Not surprisingly, for-sale listings are on the rise.

Who can buy homes at present prices and rates? Very, very few. Who wants or needs to reduce their real estate holdings and related debt–more and more every day.

Home Builders will likely be cutting home prices over the winter of 2023 due to a big drop in home buyer traffic. The National Association of Home Builders reported that buyer traffic is collapsing again due to higher mortgage rates. This suggests that builders will need to begin cutting prices of houses again to avoid a big run-up in inventory. Here is a direct video link.

When bank economists get bearish, you know that data looks pretty dour. Kudos to Robert for candour in this interview.

Robert Kavcic, senior economist at BMO Capital Markets, joins BNN Bloomberg with his perspective on Canada’s July GDP data, which Kavcic says was flat. He says all told, assuming growth remains modest in September as the impact of high-interest rates continues to bite, that leaves the Canadian economy on track for a flat-to-very low positive print for all of Q3. Kavcic says the Bank of Canada still has their eyes on stubborn core inflation and firm wage growth. Here is a direct video link.

The chart below shows Canada’s real GDP (in blue since 2021) and the grim per capita reality (in yellow). Canadian consumer sentiment is negative for a reason: there are increasingly fewer resources to go around.

It’s no wonder that even with ‘free money’ mania in 2021, Canada’s TSX (below courtesy of my partner Cory Venable) has gone nowhere in 28 months and gained just 1.91% annualized since the last cycle top in May 2008 (when oil was topping $140 a barrel).

A mild 20% bear market from here would evaporate the TSX’s price progress over the last 15 years (see red band). A 40% bear market (similar to in 2000-02 and 2008-09) would expunge all price gains since the August 2000 top–23 years ago. Believe it or not.

It bears remembering that oil price spikes are typical late-cycle and help to trigger price-deflating recessions and global demand destruction. Fossil fuel companies (18% of the TSX  index, top black line below) have been the only sector propping up the Canadian stock market since January 2022. Meanwhile, the financial sector (30% of the index) continues to lead the broad market and economy lower from here. Financial shares, -19% so far, are not yet discounting the magnitude of the credit crunch presently unfolding.

Most investors are holding portfolios designed to track the broad indices lower from here. Worse this cycle, Canada’s record debt and mean-reverting real estate market will magnify the pain.