Bond Yields are Responding

Steve Saretsky -

The worlds most important central bank, the US Federal Reserve, raised rates another 75bps this past week. The following day, second quarter GDP contracted 0.9%, marking the second straight quarter of contracting economic growth. While policy makers are not officially calling it a recession, we are arguably in one already. As highlighted by the always brilliant David Rosenberg, Back-to-back GDP contractions may not be the official definition of recession, but the reality is that whenever it’s happened in the past, the economy was in recession.

Rosie added, “It hasn’t dawned on most people that the first-half GDP contraction reflected the inflation, equity market, and fiscal withdrawal shocks. The Fed-induced rate shock comes next. This recession is going to have legs.”

Remember, monetary policy works on a lag, and research suggests it takes anywhere from nine months to two years to filter through the real economy. In real life, it feels much quicker than that.

Surveys of consumer sentiment are already below the 2008 troughs and the University of Michigan survey of consumer sentiment recently took out its lows from the original Volcker era in 1980 — when gasoline was being rationed and unemployment hit 7.5% on its way to a pre-Covid record of 10.8%.

Housing is also adjusting quickly. Greater Vancouver home sales just recorded a 22 year low for the month of July. There were just over 1900 home sales this month, the lowest count since July of 2000. That’s not adjusting for the increase in population or housing stock either. Early indications suggest the Greater Toronto area has just posted three consecutive months of multi-decade lows in home sales.

When the two largest metro housing markets in all of Canada come to a standstill it’s only a matter of time until this trickles through the rest of the economy. The knock-on effects of fewer home renovations, furniture purchases, moving companies, lawyers, land transfer taxes, etc. We’ve seen a more than a doubling of interest costs on an economy levered more than three times GDP. It’s no question the economy is going to hit a wall. Economic growth in Canada was on track for a small increase of 0.1% in June, after stalling in May.

Bond yields are now responding, the Canada 5 year bond yield is down more than 100bps over the past month, over expectations of much weaker growth. I know the word du jour is inflation, but I think those concerns will soon fade, as difficult to comprehend as that may seem, and this is coming from an inflation bull myself.

At the end of the day, this is a highly levered economy that is going to suffocate on higher interest rates. Just for context to understand where we are right now. House prices would need to drop about 25% in order for mortgage payments to be as “affordable” as they were at the peak of the market earlier this year.

Let’s assume 80% LTV, 30 year amortization on a million dollar house. Mortgage rates double, but price declines 25%.
$800k mortgage at 2.5% = $3156
$600k mortgage at 5.0% = $3202

Falling asset prices and a reduction of debt (money) sure sounds disinflationary to me. It’s also worth considering policy makers are reactive, not proactive. In other words, they will pivot, but likely way too late.

Three Things I’m Watching:

1. Market sentiment is pretty bearish, nearly 85% of Twitter poll believes national house prices will drop 15% or more this cycle.

2. Global credit impulse has turned sharply negative. (Source: Macro Alf)

3. Trigger rates on variable mortgages won’t be as bad as expected. Most borrowers won’t be impacted this year, but issues could arise at renewal if little principle is paid down. (Source: National Bank)

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The Saretsky Report. December 2022