When the Bank of Canada and then the US Fed signaled to the market in November that they had most likely reached the peak in interest rates, the market rallied. Not just the equity markets- as they responded to an outlook of cheaper borrowing rates on the horizon, but also the Bond Markets- as they recognized that the current bonds that are being offered were now probably at their best yields.
And it was what happened in the bond market that was the major story. It marked the end of the unprecedented low rate environment that began with the 2008 credit crunch and near collapse of financial systems. The 0% interest rate story was over. Now we were back to the 3-6% interest rate environment for the foreseeable future.
Because Bonds trade on an exchange just like stocks do, when the Bank of Canada raises interest rates investors can get higher yields on bonds elsewhere and aren’t willing to pay as much for what you have in your portfolio. Thus, the bonds you hold go down in value.
When Central banks stop raising rates though, and the outlook is that they are going start to drop, that momentum switches direction. The bonds you hold are all of a sudden more attractive and investors will pay more for them. That is what happened in November, which saw most bond indexes up 6-8 % in the month.
I was at a portfolio management conference around this time and the Fixed Income managers could be described as “giddy”. There was a clear sigh of relief as they now had yield in their portfolios. Two managers opened their presentation with the words “We’re Back!”. And after 15 years of tough sledding, they were.
Investors should be happy. The majority of investors are balanced investors. 40% of their holdings are in Bonds. For the last 15 years we’ve had challenges for that side of the portfolio, and there were multiple articles saying that the traditional balanced asset allocation model is broken. Well, it’s working again.
It is important to know though that this is back to normal. Rates aren’t high. The Bank of Canada Rate is currently 5%, and we will are probably in the 3-6% range for the next 20+ years, so get used to what is happening right now.
This is having an effect on the real estate market. It should be noted that the biggest factor in housing prices is actually employment figures, not interest rates, and the unemployment rate is still very low (arguably too low). This makes sense if you think about it. If rates go up it will affect what a purchase price is that someone can afford, but they can still afford something. Instead of affording to buy a 1M home, they can afford to buy a 950K home… so the real estate market still has a floor, it’s just a little lower. The buyer is still there looking. But when you pull buyers completely out of the market because they all of a sudden have zero income, and force some of them to potentially sell their homes, doubling down on the supply/demand equation- that is a much more dramatic effect. That’s where the bottom can fall out.
The affect of interest rates hikes on mortgage holders is also delayed, as most Canadians have fixed rate mortgages on a term. The 20 fold increase from 0.25% to 5% isn’t realized until the mortgage renews, and that is happening now. I keep hearing different figures and different time frames, but suffice it to say 30-40% of mortgages are renewing in the next 12-18 months.
So far, delinquencies are unaffected. Canadians will make other sacrifices before missing a mortgage payment and we are seeing that: reports are showing that credit card and loan balances are rising. Spending is dropping, as evidenced by the low inflation numbers out yesterday of 2.9%. Canadians are tightening their belts. All that said, we aren’t concerned with mortgage defaults at this time.
What is important is that Real estate values have dropped. There’s no bubble that has burst, nor are we predicting it, but we feel we are in a sorting out period where buyers and sellers are coming to grips with this new reality. And this may last a while, as more and more mortgages renew at these normal levels, and people can be stubborn not coming to grips with the new reality of a lower market. Investment properties may start to go up for sale as the rents needed to pay the debt don’t make sense and don’t attract renters, adding to the real estate supply.
People ask about a real estate bubble, and as I have outlined above, for that to happen unemployment needs to cross from “too low”, to “normal”, and then into “too high” territory, which at this point we don’t see on the horizon.
Below is a link to a piece showing the history of the TSX vs. different real estate markets in Canada, and the result will probably surprise most of you.
The TSX vs Major Canadian Real Estate Markets
Keep in mind that the other major index we Canadians invest in is the S&P500, and those returns are greater than the TSX.
outlook for the stock market is good. We are in a period now where we may see a pull back, but we are on the search of the next bull market. It is similar for the bond market. It’s pulled back a bit so far this year as the rate drops aren’t probably coming as soon as was thought back in November, but they’re coming. We think the first will come in June or July this year, and we could see four 0.25% drops by the end of the year.