October 2023

October 19, 2023 | Derrick Lahey


“In investing, what is comfortable is rarely profitable.”

Robert Arnott


In my last market commentary I discussed some of the important differences in the standard mortgage terms between Canada and the USA and how those differences are exerting influence on the respective economies. As a reminder, mortgage interest is tax-deductible for Americans so the vast majority of homeowners perpetually refinance their homes when they have positive equity and when they do this they consolidate their other debts like credit card balances into a home mortgage for tax reasons. During Covid, 30 year mortgages were as low as 3% so one had to be in a coma to not take advantage of that opportunity of 30 year rate certainty. With mortgages representing 80% of consumer debt in the USA, most consumers are still feeling confident even in the face of these surging interest rates. As a reminder, the US consumer is about 70% of the US economy and as the US economy is the largest in the world, as goes the US consumer so goes the global economy. For those wanting to enter the US housing market, 30 year rates are now 8% and since mortgages are not portable in the USA like Canadian mortgages, nobody wants to sell their home and walk away from their 3% mortgage.

In addition to the direct impact that 30 year mortgages have had on the US consumer there is another huge “shock-absorber” in the US economy with respect to the outcome of surging interest rates. As I have discussed in prior letters, the US Federal Reserve engaged in massive Quantitative Easing at the beginning of Covid. As a reminder, QE is when the central bank creates money on its own account and uses it to buy bonds which pushes bond prices up, yields down and importantly injects liquidity into markets. The seller of the bond then has cash that they redirect into other bonds or some other asset so it really is the same thing as “printing money” for all intents and purposes.

Prior to the 2008 Great Financial Crisis, the Fed’s balance sheet was less than $1 Trillion in value and by the end of the crisis, it was over $4.5 Trillion. The Fed managed to work that balance down to around $3.5 Trillion and decided that would be the new level to target. When Covid appeared, the Fed resumed the QE program and by the time it had peaked, the balance was over $9 Trillion! From less than $1 T to over $9 T in 15 years. In the effort to fight inflation, the Fed has not only been raising interest rates directly, it has also been draining liquidity through Quantitative Tightening. This means when bonds held by the Fed mature, the cash pays down the outstanding $9 Trillion balance. The tightening effort got the balance down to around $8 Trillion and then we had the regional bank failures in March as interest rates went up so quickly. Through a separate special lending facility, the US Treasury has extended around $500 Billion to the banks which managed to short-circuit that crisis. While this special facility is only good till next March, it seems highly likely that it will need to be extended as interest rates have continued to rise higher.

This brings me to a very important difference between this interest rate tightening cycle and every tightening cycle that preceeded the Great Financial Crisis of 2008. As bonds lose value when interest rates increase, the $8 Trillion in bonds that the Fed hoovered up have lost value to the tune of $1.5-2 Trillion. Had those bonds been in the market (held by investors) during this tightening cycle, those losses would be directly hitting the economy and the long-anticipated recession would most likely have been declared by now. But this time those losses are outside of the “real world” and are just sitting on the Fed’s books. That is some creative accounting!

So not only has the US consumer been largely immunized from higher interest rates, much of the overall economy has also been shielded from the bond losses that have resulted from drastically higher interest rates. All that said, some stress is starting to show with US credit card balances now greater than $1 Trillion for the first time in history (up from around $900 billion in 2019) and credit card defaults are at an 11 year high. Auto loans which have much shorter durations like Canadian mortgages are climbing with US auto loan balances now topping $1.5 Trillion. The stocks of retailers from the high end like Nordstrom’s, to mass market like Macy’s and Foot Locker all the way down to the low end like Dollar General have all plummeted to fresh cycle lows indicating cracks are finally showing up across all consumers. And all this before the resumption of student loan repayments which kicked back into gear this month after a 3 year+ Covid moratorium.

By the way, every other central bank in the world including the Bank of Canada has charted the same path since Covid but the numbers are just less startling. And the shorter duration in the Canadian mortgage market is already biting the Canadian economy. For example, at the start of this year, RBC had practically no exposure to 35 year mortgage amortizations and now that number is closer to 25% with many other banks carrying higher percentages. In the face of much higher rates many homeowners have had no choice but to take a longer amortization on their mortgages when they are forced to renew. And many investment properties are in a “negative carry” situation with rental increases not keeping up with refinancing costs.

While it is well documented that Canada has one of the most over-valued real estate markets in the world, we also have one of the highest immigration rates of any developed economy at around 3.5%. While the stated immigration goal is around 500,000 per year, last year it was closer to 1 million when all categories are included. For example, about 1/3 of all international students become permanent residents after graduation. This massive amount of immigration has helped to shore up our housing market in the face of the doubling in financing costs. This is why we haven’t seen and are unlikely to see a housing calamity like the US experienced in 2008.

I am still in the camp that central banks have raised rates too aggressively in this cycle but I have to acknowledge the factors outlined above that make it “different this time” (the most dangerous words in investing!). The Federal Reserve tends to raise interest rates until “stuff breaks” but it also seems to be willing and able to respond to those breaks with its seemingly unlimited tools and resources.

Longer term bond yields have been climbing rather dramatically very recently and the optimists say this is because the economy remains strong and resilient. While this is possible, it is more probable that the surging bond issuance simply requires higher interest rates to entice buyers. With China and Japan reducing their ownership of US Treasuries, and the Federal Reserve trying to work down its massive outstanding balance of US bonds, higher rates are just a fact until the economy hits a wall and then we will see lower rates. Timing recessions has always been very difficult and with central banks being more influential than at any other time in history, it is harder than ever. But I remain in the recession camp for 2024 and lower rates will be the inevitable response when we have sufficient economic weakness and more tolerable levels of inflation (2-3%).

In the face of higher interest rates, most stock indices have gone nowhere for well over 2 years and while this sounds gloomy, in many ways markets have tolerated the huge back up in interest rates better than most would have expected due in part to the factors outlined above. While bonds have been brutalized, they are now yielding more than they have in 20 years and the current running yields will absorb a lot of additional pain should rates move much higher which will support higher assets prices again. We remain defensively positioned in a very challenging environment but as always, focused on quality for the long term.