In the wake of Donald Trump’s surprise election victory on Nov. 8, bond markets have been swept up in one of the biggest selloffs in history.
In the wake of Donald Trump’s surprise election victory on Nov. 8, bond markets have been swept up in one of the biggest selloffs in history. Expectations of a rebalancing from monetary to fiscal stimulus are on the rise, spurred by the president-elect’s campaign promises to boost infrastructure spending, cut taxes and roll back a host of regulations, as well as the near-certainty of the U.S. Federal Reserve raising rates in December. As yields have risen in recent weeks, the market value of the global bond market has fallen by over $2 trillion. At the same time, equity markets have been buoyant and hopes for a resurgent U.S. economy are running high.
But events south of the border could well throw a major risk factor north of the border — Canada’s super-heated housing market — into stark, negative relief.
Rates are rising, not just in the U.S. but in Canada as well. From Nov. 8 to Nov. 24, Canadian benchmark five-year government bond yields rose by 23 basis points, while 10-year yields rose by 28 points. The yield curve — as measured by the difference between yields of two-year and 10-year government bonds — has steepened, by about 22 basis points. Those moves reflect an underlying assumption that we are now in a regime shift, away from the post-recession falling-rate environment and towards a higher-inflation, higher-rate landscape.
The implications of this shift, should it continue, may be widespread and various. But perhaps nowhere will they be felt as sharply as in the Canadian housing market.
Housing prices have climbed steadily since the recession, and Canadians have become more and more indebted. Total household debt in Canada now exceeds GDP, and outstanding mortgage debt has grown by more than 30 per cent over the past five years. An indication of how thin the interest rate ice may be under some households was highlighted in a recent1 report from National Bank suggesting that 12 per cent of households have debt/income ratios greater than 250 per cent and owe 40 per cent of overall household debt in Canada. With rates on the rise, cash-strapped Canadian homeowners can look forward to higher refinancing costs over time. As a result, the Canadian economy could face a contraction in consumer spending or an increase in loan defaults — or, of course, both.
The offset to rising rates is higher wages; if inflation drives wages up at the same pace rates rise, then it may be a wash. However, that outcome is not at all certain, and the reason is, once again, Donald Trump. His promises to scrap or renegotiate the North American Free Trade Agreement; if implemented, this could have severe negative implications for Canadian trade (which comprises about two-thirds of GDP) and therefore on wages.
Meanwhile, domestic developments, such as foreign investment restrictions introduced in British Columbia this summer and the federal government’s tightening of mortgage insurance rules for first-time buyers, are likely to impact housing demand. On top of that, mortgage rates may be set to rise even if bond yields stay at current levels. The Canada Mortgage and Housing Corp. has proposed changes to default-risk sharing with lenders, which would raise banks’ funding costs, and which, as expected, will be passed on to borrowers.
Taken alone, any one of these factors could throw cool water on Canada’s hot housing market. Taken together, they could provide an icy shock, resulting in fewer market entrants and/or fewer homeowners who can afford to refinance. The housing market has accounted for a good portion of Canadian GDP growth post-recession, and so the risk is not insignificant that a downturn there could set off a chain reaction across the wider economy, potentially tilting Canada into recession.
This might not happen, of course. Renewed optimism in the stock market might carry over into the U.S. economy growing faster than forecast; barring negativity on trade, that could have a positive spill-over effect on Canada. Rising rates could be cushioned by higher economic activity, and asset prices could rise.
As well, while we believe rates will trend higher, they might not trend significantly higher. The question is, what is significant? If borrowing costs rise by only 30 basis points, would that be enough to cool the market? What about 60 points, or 90?
Granted, many factors have yet to play out, and risks around Canada’s housing market are not news. We believe, however, that those risks have increased.
Source: Bloomberg and BlackRock Investment Institute.
 Brave New World: Canadian Domestic Systemically Important Banks (D-SIBs) and Domestic Housing Finance. National Bank Financial, November 2016.
Aubrey Basdeo is a managing director and head of Canadian fixed income for BlackRock. He is a regular contributor to The Blog and you can find more of his posts here.
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