Danielle was a guest with Jim Goddard on Talk Digital Network, talking about recent developments in the world economy and markets. You can listen to an audio clip of the segment here.
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Danielle’s biweekly market update
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Easy money has yielded a vicious payback period
Interest rates and high debt levels are biting hard in Canada; the economy is weak, and layoffs are rising.
Toronto’s new home sales were down 71% compared to May 2023, with new condo sales down 75% and new single-family home sales down 65%. The same period saw an increase of 20,427 new home listings in May (16,845 condos and 3,582 single-family homes) compared with 936 new home sales (539 condominium units and 397 single-family homes), according to the latest Altus Group analysts and the Building Industry and Land Development Association report.
At the current sales pace, the existing listings would take 14.5 months to sell. See, ‘Nothing is moving’: GTA sales of newly built homes plummet in May.
Lower home prices are disinflationary and part of what the Bank of Canada has been targeting. Unfortunately, rents and higher mortgage rates are working at cross-purposes.
The masses remain priced out of home ownership, and landlords are trying to cover higher carrying costs with higher rents. An 8.6% average rent increase year-over-year in May (on the lower right since 2016, courtesy of The Daily Shot) helped push the core Consumer Price Inflation Index (CPI) up 2.9% year-over-year (on the lower left) vs. 2.6% estimated.
The problem is that shelter costs comprise 30% of Canada’s CPI basket. Twenty-four percent of shelter inflation is driven by changes in average rents (blue line below since 2018, courtesy of RBC), and 13% by mortgage interest costs (yellow line).
As the inflation rate has fallen since last fall, Treasury bond prices have risen, lowering their yields and starting to bring down interest rates in the banking system. Lower rates help reduce the payment shock as thousands of ultra-low-rate pandemic-era loans come up for renewal.
But yesterday’s CPI surprise–the first month-over-month increase in five months—lowered the odds that the Bank of Canada will ease overnight rates again at its July 24 meeting. Treasury bonds have sold off sharply on the news (yields higher), pushing interest rates back up.
Higher rates and rents drive shelter inflation, constraining rate-cutting room and driving less spending, more layoffs, and even more economic lethargy. The Bank of Canada wants to lower rates, but quick fixes are not in the cards here.
Years of recklessly low interest rates have made this mess, and the payback period is vicious.
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Lags demand respect
The US 10-2yr Treasury yield curve has been inverted (two-year yields higher than ten-year) for 23 months since July 2022. An inversion in this spread has preceded the onset of every recession in the last 50 years by an average of 10 months. Generally, longer-than-average inversion periods (11 months Sept 12, 1980 to Oct 23, 1981, 19 months Dec 13, 1988, to June 29, 1989, 12 months Feb 2 to Dec 28, 2000 and 18 months Jun 8, 2006 to Mar 20, 2007) preceded deeper than average loss cycles for stocks and real estate.
However, market participants have short attention spans and the longer the inversion lasts, the more the consensus typically dismisses the indicator as no longer relevant. History says that’s a mistake.
The 10-3 month yield spread offers a similar heads up to the onset of recessions with an average lag of 15 months, as shown below since 1975 courtesy of Tom McLellan, see Yield curve’s 15-month lag:
This week’s chart shows the spread between the 10-year and 3-month Treasury yields. It is shifted forward by 15 months to help illustrate how GDP responds with that lag time. This yield spread first inverted on a monthly basis back in November 2022. Counting forward by 15 months takes us to February 2024, which was in the first quarter (Q1). We did not get a negative real GDP growth rate in Q1, but it did fall to a very low positive number. The full effect of the current inversion of the 10y and 3m rates has not yet been felt.
Moreover, once Fed cutting cycles drop short rates, the curve starts to normalize or “disinvert,” but rate relief to the economy also takes a multi-quarter lag:
Furthermore, that economic effect should continue to be felt for a period of 15 more months after the 10y-3m spread finally disinverts. In other words, the FOMC members might believe that they are fighting current inflation right now by making current economic conditions tougher via their high interest rates. But in reality, the effect is delayed, and so the continuing inversion of the yield curve means poor GDP conditions for 15 more months after the moment when the yield curve disinverts. And we do not see any sign yet of any disinversion happening anytime soon.
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