Juggling Dynamite

David Rosenberg, founder and president of Rosenberg Research, joins BNN Bloomberg to discuss his outlook for the Canadian economy amid rising rates. Rosenberg says the Canadian economy will receive the payback from the BoC’s tightening cycle, and he expects a recession to occur next year. Furthermore,Rosenberg adds the BoC could be forced to cut rates in the second half of 2023. He also says there could be a diverge between the BoC and the Fed upcoming rate decisions as the Canadian household balance sheets more stretched than the U.S. household balance sheets. Here is a direct video link.

The Bank of Canada raised policy rates another 50bps today, taking base rates in the banking system to 4.25% from .25% at the start of the year. As we look into 2023, it bears remembering that monetary changes move through the economy with lags of up to two years. The Bank of Canada explains on their website as follows:

When we adjust our policy interest rate at the Bank, we don’t expect immediate results. It usually takes 18 to 24 months to see the full effects. Interest rate changes affect the economy through four main channels:

• commercial interest rates—what you pay on mortgages and loans and what you receive on deposits
• the Canadian dollar exchange rate
• people’s expectations for inflation
• the prices of assets such as houses, stocks and bonds

In other words, the massive increase in Canadian base interest rates over the past nine months has barely begun its demand destruction effects on the economy.

Some 20% of Canada’s $2 trillion in mortgage debt was borrowed when rates were 1.5% compared with more than 5% today (BMO data). Variable mortgage rates have already tripled year to date, and some 35% of fixed terms are up for renewal in 2023. So it’s not surprising that home sales have collapsed, and prices are falling nationally, down 9.9% year over year in October (CREA).

Mortgages are not the only credit that’s inflicting stress, of course. Vehicle and education financing, commercial loans, lines of credit and credit cards have all helped push household interest costs to a record 10% of Canadian household income in 2022.

As demand weakens for goods and services, the 3-month annualized core inflation rate has been falling faster than projected (shown below since 2010 courtesy of The Daily Shot).
With Canadians some of the most debt-laden and cash-strapped of major economies and our economic growth and net worth more concentrated in real estate than most, inflation forecasts for Canada have fallen since June (below in red since 2020) compared with the Eurozone (in black), and America (in blue).

All of this suggests that today could end the Bank of Canada’s hiking this cycle. The options market predicts a terminal funds rate of less than 4.5% (as shown below).

Even without more hikes, billions in Government of Canada bonds set to mature and roll off the Bank of Canada’s balance sheet in 2023-24 (QT) will further tighten financial conditions.

The treasury curve sees the forest for the trees. Yields have plunged over the past month (government bond prices have risen), and the spread between Canada’s 30-year and 3-month Treasury yield has inverted to a jaw-dropping -1.376. This is a bet from the math-focused bond market that the Bank of Canada will cut short rates again in 2023.

But back to those multi-quarter policy lags. To try and maintain respect for their process, central banks like to leave many months between their last hike and their first cut; otherwise, the whole “measured response” mantra looks circumspect. Once they start cutting, it will also take many months for that to alleviate credit strain. 2023 is going to feel like tough love for many.

December 14 is expected to mark the US Fed’s 7th consecutive rate hike this cycle with a 50bp increase that will take the fed funds rate to 4.25-4.50%, the highest since December 2007. Chair Powell says they intend to hike more in 2023. We shall see!

As of last Friday’s close, the 10-year minus 3-month US Treasury yield spread reached -83 bps. This degree of curve inversion has only happened three times in the previous 60 years, as shown below: 2000 (recession followed in 2001), 1979-82 (recessions in 1980, 1981-82) and 1974 (recession 1973-75). A 60bp inversion in February 2007 preceded the  “great” recession (December 2007 to June 2009).
Higher short-term rates increase cash and bond yields to the benefit of savers. For debtors, real estate and equity owners, the opposite is true.

All four of the previous steepest yield inversions preceded the deepest bear markets of the last 40 years when stocks underperformed government bonds by 32 to 65% (as shown below courtesy of Absolute Strategy Research) after the US Fed had paused its tightening efforts (the last pause meeting before the first cut is marked below).
Worse this time, after a 40% leap in the M2 money supply from 2020-21, the last seven months have marked the sharpest decline (-1.5%) since at least 1959. As shown below (courtesy of Zerohedge), the upside is that inflation (CPI) is set to follow M2 lower. Plunging liquidity in the financial system is sparking the fastest decline in single-family home sales of any Fed tightening cycle on record (2022 in red below courtesy of Macro Alf), along with cascading strife through real estate-focused funds and investment products.

This makes macro sense because, as shown below, courtesy of Charlie Bilello, the US median housing payment now takes 46% of the median household income compared with 42% at the last housing bubble peak in 2006. After 2006, US home prices fell 26% nationally until median housing payments reached 26.7% of the median household income. Median prices stayed less than 33% of household income until the 2021 explosion. This time a median price drop of 26% would only take US national home prices back to where they were in the fall of 2020. That would be a modest retreat in the big picture.