Not Until Something Breaks

Steve Saretsky -

Happy Monday Morning!

It looks like inflation might not be transitory after all, and the bond market is finally figuring that out. Bonds have been selling off hard lately, sending yields much higher, and tightening financial conditions in the process. This is particularly important for the Canadian housing market. If there was ever a catalyst to prick the bubble that everyone has been talking about for over a decade it would be higher mortgage rates crushing demand and highly leveraged households.

I would argue the 5 year bond in Canada is the most important metric to watch. The 5 year bond yield effectively prices the 5 year fixed mortgage rate. It took a 30 year high in inflation and a war to finally get it moving, but the 5 year bond yield has been on a tear in recent weeks. It is now sitting at 2.497%, the highest reading since 2010. As a result, fixed rate mortgages are on the move, with all major Canadian banks now offering mortgage rates north of 3.5%, and they could reach 4% within the next few weeks.

Some banks have had to increase fixed rates 3 times over the past week, trying to keep up with the rapid move in funding costs. Mortgage brokers who have been in the business for over 20 years tell me they have never seen such a rapid move like this before. This will absolutely slow home buyer demand, it already has. Let’s run some simple numbers here.

At the start of the pandemic, national home prices were $580,000 and mortgage rates at 1.5%. Assuming 20% down and a 25 year amortization that resulted in a monthly payment of $1855. Fast forward to today, the national home price index is $870,000 and if/when rates hit 4%, that monthly payment would be $3661. That is effectively a DOUBLING of the typical mortgage payment. With housing affordability already a stretch, you can see something will likely have to give.

You can whip out a mortgage calculator and draw similar conclusions for Greater Vancouver & Greater Toronto. When you factor in the rise in home prices and the subsequent rise in mortgage costs, payments in Greater Vancouver rise an extra $2231, and in the GTA by an extra $2828 per month.

A lot of buyers are already relying on parents co-signing mortgages just to get approved. Now what? Add on the rising cost of fuel and food, two essential inputs into our day to day lives and the equation gets even more complicated. Households are getting squeezed and that will show up in the housing market sooner rather than later.

Oddly enough, every big bank economist is still calling for eight rate hikes this year, and those same forecasts believe there will be no decline in home prices. Really?

What’s important to take away here is that in a highly leveraged society it doesn’t take much to tip the boat. Rate hike forecasts remain highly optimistic and assume the economy (and the housing market) can handle it. I don’t think they can.

Don’t forget, in 2018 when mortgage rates hit 3.5%, home sales in Greater Vancouver and Greater Toronto witnessed 10 year lows and prices dipped, and would have likely kept sliding without central banks ultimately pulling the cord on that rate hiking cycle.

I think the cord gets pulled prematurely again, but not until something breaks first. Let’s watch.

Three Things I’m Watching:

1. Canada 5 year bond rips to highs last seen in 2010. (Source: CNBC)

2. Canada’s mortgage debt grew 10.6% or $188 Billion over the past year. (Source: Richard Dias)

3. Mortgage renewal gap is the highest it’s been since the early 90s. A $400k mortgage taken out in Mar 2017 will see payments jump ~$280/mo at renewal on standard 5 yr fixed term. (Source: Ben Rabidoux)

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The Saretsky Report. December 2022