Memo 1: Bond investors react as US drags feet on debt ceiling resolution
Bond yields have been on a veritable rollercoaster from the start of the year, with the latest developments south of the border causing another climb.
Uncertainty over the resolution of the US government’s $31.4-trillion debt ceiling have roiled markets, causing the Dow to drop for five consecutive sessions, and setting the S&P 500 up for its lowest weekly performance in two months. Bond investors have been no exception, pulling their holdings as recession fears rise; US five-year treasuries have soared 42 basis points in the last month, up to a yield of 3.9%. And, as Canadian bond pricing tends to mirror our American neighbours, our five-year government bond has surged 54.7 basis points over the same time period, up to 3.5%.
That’s a considerable about-face from sentiment as recently as March, when US banking crisis fears drove yields lower, leading several lenders to discount their fixed-rate offerings. The opposite has been unfolding this week, with fixed rates ticking up across one-, three-, and five-year terms; currently, the lowest five-year fixed mortgage rate in Canada is 4.49%, a 20-basis-point jump from the 4.29% available as recently as May 8th.
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However, things could shift in the coming days – there’s optimism that US President Joe Biden and congressional Republican Kevin McCarthy are coming close to finding a solution for the nation’s debt limit, along with a spending plan; progress that’s sure to be taken in stride by investors.
In the meantime, the best thing mortgage shoppers can do is lock in a rate hold, and ride out this most recent flavour-of-the-week volatility.
Memo 2: Rising mortgage rates and home prices push Canadian debt to dangerous levels
As interest rates have soared, so too have Canadian households’ debt levels – and that’s posing a significant risk to the country’s economy, according to the Canada Mortgage and Housing Corporation.
A report released this week by the Crown Corporation’s Deputy Chief Economist Aled ab Iorwerth reveals Canada has the highest level of debt among the G7 countries – and that three quarters of that is made up by mortgages. In fact, writes ab Iowerth, debt levels outpaced the size of the Canadian economy in 2021, and have grown ever since. In contrast, back during the 2008 recession, debt levels stood at 80% of the economy, and 95% in 2010.
Meanwhile, in the US, the opposite is happening; debt levels dropped from 100% of GDP in 2008 to 75% in 2021. The main culprit, posits the report, is the steep unaffordability of Canada’s housing market.
“So as house prices increase in Canada, households take on debt leading to a rise in the total amount of debt in the economy,” writes ab Iowerth. “Longer term, reestablishing housing affordability in Canada will be key to reducing household debt if they want to become homeowners.”
Of course, rising mortgage rates as a result of the Bank of Canada’s inflation fight haven’t helped. The latest inflation data revealed Canadians are paying 28.5% more this year in mortgage costs than in April 2022. The report also points to how today’s overall higher rate environment will also pose challenges for those coming up for renewal within the next few years.
“Over time, these higher interest rates translate into higher mortgage payments for households when those on fixed 5-year terms renew at higher rates,” states the report. “Those facing the most challenges are those with variable rate mortgages who see higher interest rates immediately.”
The CMHC’s take echoes a similar alarming Financial Systems Review report out this week from the Bank of Canada, which warned fixed-rate borrowers will likely see payments spike by 25% upon renewal, while variable borrowers on fixed payment schedules can expect a whopping 40% increase.
Debt-laden households are especially vulnerable to economic shocks, says the CMHC, despite the stress-testing safeguards put in place in recent years by the banking regulator.
“Although the Canadian financial system has been stress-tested for significant losses — which will stop an economic downturn from being amplified through a Canadian financial crisis — widespread job losses in an economy where debt levels are high will make any recession more severe,” reads the report, which points out that record-low pandemic-era mortgage rates are likely a thing of the past.
“Our concern about debt is exacerbated by concerns over interest rate levels in the long term. Although the last decade was characterized by historically low interest rates — and slow economic growth that some economists called ‘secular stagnation’ — there is no guarantee that we will return to such a pattern after currently high inflation is addressed and interest rates start to decline.”
Memo 3: Canada’s big banks hedge their bets against “bad loans”
It’s not just consumers who are being squeezed by rising debt levels – Canada’s biggest banks are feeling it, too.
Following a week of disappointing earnings reports, it’s come to light that the “big five” are being extra cautious when it comes to doling out credit, bulking up what’s called their “loan loss provisions”.
This means lenders are increasingly concerned about Canadian borrowers’ ability to pay back debt, with the likelihood of defaults on the rise. According to the banks’ second-quarter earning reports, BMO, TD, Scotiabank, RBC, and CIBC have each set aside hundreds of millions – or in the case of BMO, $1.2 billion –more compared to last year, just in case borrowers can’t pay their loans due to the spike in inflation and subsequent borrowing costs. The possibility of a recession is also weighing heavily on lenders’ minds, according to analysts.
In an interview with BNN Bloomberg, Andrew Pyle, senior investment advisor and portfolio manager at CIBC Wood Gundy, said: “This week we’re looking at approximately $3 billion set aside from five Canadian banks and that’s a significant change from last year.”
“When it appears that borrowers might not be able to maintain their loans, banks make a forecastable risk by putting aside a certain amount of their earnings should they need that capital to address short falls in lending, this is known as loan loss provisions.”
The silver lining is the fact that Canadian lenders have the ability to squirrel away extra funds speaks to their stability and overall healthy capital.
“If something goes wrong, they have the capital to deal with that stuff,” Paul Harris, partner and portfolio manager at Harris Douglas Asset Management, stated to the news outlet.