Bank of Canada: Have we entered a new era of structurally higher interest rates?

[Viking]

Yesterday, the Bank of Canada delivered a surprise rate increase. Today they provided more details of why… what a shocker:

 

“A lot of uncertainty remains. But it’s possible long-term interest rates will be higher in the coming years than what Canadians are used to,” Beaudry said on Thursday. By outlining these key forces, Beaudry said he hopes he “will help people be prepared in the eventuality that we have entered a new era of structurally higher interest rates.”

—————

Bank of Canada Suggests Higher Rates May Not Have as Much Bite

- https://www.bloomberg.com/news/articles/2023-06-08/bank-of-canada-flags-upside-risk-to-neutral-rate?srnd=premium-canada

In a speech to the Greater Victoria Chamber of Commerce a day after policymakers raised the benchmark borrowing rate to 4.75%, Deputy Governor Paul Beaudry flagged concerns about a reversal in core inflation and said officials were surprised by household spending on goods and services.

 

He also said that neutral rates — a theoretical level of borrowing costs that neither stimulate nor restrict the economy — may drift to higher levels compared to before the pandemic. Beaudry said stalling globalization, rising wages, and increasing investment opportunities in artificial intelligence as well as the transition to a low-carbon economy were contributing to the increase.

 

“A base-case scenario where the real neutral rate remains broadly in its pre-pandemic range is possible, but the risks appear mostly tilted to the upside,” Beaudry said, adding that there was “meaningful risk” neutral rates could go up.

 

While Beaudry was careful to note that the current neutral rate is still volatile, the comments will fuel speculation policymakers at the Bank of Canada are increasingly of the view their aggressive increases to interest rates are less restrictive.

 

The statement, which came a day after the bank raised borrowing costs for the first time in three meetings, also highlighted the possibility rates need to move higher for longer in order to bring inflation to heel.

 

“A lot of uncertainty remains. But it’s possible long-term interest rates will be higher in the coming years than what Canadians are used to,” Beaudry said on Thursday. By outlining these key forces, Beaudry said he hopes he “will help people be prepared in the eventuality that we have entered a new era of structurally higher interest rates.”

Edited June 9, 2023 by Viking

[John Hjorth]

@Viking,

 

Well, the Canadian residential real estate market has over the years been discussed to skinlessness here on CoBF - I read all those discussions as about a bubble, that consistently, persistently and stubbornly refuses to burst. 

 

What is your view and thinking on what will happen to the major Canadian banks in such a screnario? I think I have observed that you aren't shy of holding american banks when they are cheap, but I haven't seen you engage with Canadian banks at all, I think.

 

 

[scorpioncapital]

"Beaudry said stalling globalization, rising wages, and increasing investment opportunities in artificial intelligence as well as the transition to a low-carbon economy were contributing to the increase."

 

Of course no politician will ever add the key element to the list - the stupidity of the country itself!

 

[SharperDingaan]

This is press spin; the reality is that 'structurally higher interest rates' will only be temporary.

Simply 'cause as more people get forced into selling their homes because the mortgage is no longer affordable, that rise in supply will rapidly lower house prices. More cash going to debt service, and less borrow capacity from the lower housing value, lowers spend, lowers employment, and lowers the interest rate. The real question is how best to use the deliberate 'spin' of 'highest interest rate in 20+ years'; versus 'the end of record low interest rates', and 'return to historic interest rates'.    

 

Canadian banks will do very well, but there are a lot of better alternatives.

Normal curve restoration, extended real estate loan provisioning, CBDC, fintech, etc. are still to come, and will take at least a decade to flush through. While all though that time electric grids are being rebuilt, transport fleets moved over to electric, and lower income housing being built/re-built in mass, etc. Not a bad thing.

 

SD

[John Hjorth]

Thank you, @SharperDingaan,

 

I sense the same sentiment here locally, doomsday predictions for almost eternal hardship all over the place in the local press because of these interest rate increases. The fact is that the earnings in the Danish banks in general are actually on a great tear upwards, and from what I hear from those banks CEOs I'm interested in listening to, they can't see material weaknesses in their respective loanbooks.

 

Credit has in general been tight, and has tightned materially since the GFC here. The Danish FSA has been extremely brutal towards *culprits* not doing as they were told to do. Absolutely no mercy. Very close control of the FIs. Especially about loan provisions and reserves. Now for more than a decade.

[Viking]

5 hours ago, John Hjorth said:

@Viking,

 

Well, the Canadian residential real estate market has over the years been discussed to skinlessness here on CoBF - I read all those discussions as about a bubble, that consistently, persistently and stubbornly refuses to burst. 

 

What is your view and thinking on what will happen to the major Canadian banks in such a screnario? I think I have observed that you aren't shy of holding american banks when they are cheap, but I haven't seen you engage with Canadian banks at all, I think.

@John Hjorth my guess is the Canadian banks will do ok. Canadians do not default on their mortgages. In terms of return, if you look at the last 5 years, Canadian banks have delivered a total return = dividend payout. I have bought a basket of the Canadian banks over the past year when they have sold off aggressively… and then sold them when they went up 3 or 4% (in tax free accounts). I have done this a couple of times. 
 

Canada right now has a number of attractive options if someone wanted to build a high yield dividend payout portfolio with an average dividend yield of around 5.5% (and likely a conservative total return of around 8-10% moving forward). For Canadian, in taxable accounts, income in the form of dividends is taxed at a very low level.
- Canadian banks

- Canadian telco’s

- Canadian pipelines

- Canadian energy
—————

“In Canada, mortgages are typically recourse loans. However, in Alberta and Saskatchewan—non-recourse loans are more common. If you put less than a 20% down payment on your home, you would be required to have the CMHC insurance, which automatically makes your mortgage a recourse loan.”

[Viking]

1 hour ago, SharperDingaan said:

This is press spin; the reality is that 'structurally higher interest rates' will only be temporary.

Simply 'cause as more people get forced into selling their homes because the mortgage is no longer affordable, that rise in supply will rapidly lower house prices. More cash going to debt service, and less borrow capacity from the lower housing value, lowers spend, lowers employment, and lowers the interest rate. The real question is how best to use the deliberate 'spin' of 'highest interest rate in 20+ years'; versus 'the end of record low interest rates', and 'return to historic interest rates'.    

 

Canadian banks will do very well, but there are a lot of better alternatives.

Normal curve restoration, extended real estate loan provisioning, CBDC, fintech, etc. are still to come, and will take at least a decade to flush through. While all though that time electric grids are being rebuilt, transport fleets moved over to electric, and lower income housing being built/re-built in mass, etc. Not a bad thing.

 

SD

@SharperDingaan my guess is employment is the key moving forward. If employment stays reasonable strong then i have a hard time seeing how house prices move much lower in Vancouver/Toronto. I think we will need to see a recession and higher unemployment to cause house prices to fall. And even then, the fall likely will be mild (10% from here?). 
 

We have a severe shortage of housing right now. Very low listings of homes for resale. Exceptionally low vacancy rate (around 1% i think). So the market is frozen right now. No one can move. (Rent increase for new tenants is running close to 20%; rent increase for existing tenant was 2% this year - as mandated by provincial government - after a 1.5% increase in 2022.)

 

Canada also had about 1 million immigrants come in over the last year: international students, foreign workers and regular immigration. Most want to live in Toronto or Vancouver.

 

Cost to build a condo in Vancouver is C$1,100-$1,200 a square foot. For a 2 bedroom 850 square foot apartment that is $1 million. Interest costs for builders is spiking so this cost is likely too low. About 1/3 of a builders costs today are now taxes (municipal, provincial, federal) - all levels of government need housing to chug along.

 

Bottom line, the real estate market is Vancouver and Toronto is NUTS. It is completely warped out of shape (like a pretzel).

 

The crazy thing is the housing boom has made millions of Canadians millionaires. It has also become a cultural thing… want to get rich? Buy real estate. It is everywhere in society. Hockey is no longer Canada’s pastime - it is now real estate.

 

At the end of the day, i am watching real estate closely. I have three kids, the first of who just graduated from university. I would love for all three to live in Vancouver (we all like each other…). If they don’t live in Vancouver it will likely be Toronto (the center of the world for employment in Canada). 

Edited June 9, 2023 by Viking

[John Hjorth]

Thank you for elaborating, @Viking,

 

It reads pretty wild from here. So the Vaucouver real estate market is hot because of demographic trends, inflation etc. pushing demand higher, while rising interest rates may be expected to cool things down, but not in some kind of crash.

 

The city is also limited in a way with regard to growth horisontally, because of the North Shore Mountains [A bit like Hong Kong and Monaco], right?

[Spooky]

2 hours ago, SharperDingaan said:

Canadian banks will do very well, but there are a lot of better alternatives.

 

What do you think the best alternatives are SD? I am holding a more meaningful allocation in cash these days in case there is a good opportunity.

[Spooky]

Another factor with Canadian real estate is that it has become a global capital sponge - very common for Chinese and other foreign investors to park their capital in Canadian real estate looking to get around capital controls etc. Also, many immigrants coming from countries with weak banking systems don't trust the banks and put all of their money into real estate.

[bizaro86]

1 hour ago, Viking said:

@SharperDingaan my guess is employment is the key moving forward. If employment stays reasonable strong then i have a hard time seeing how house prices move much lower in Vancouver/Toronto. I think we will need to see a recession and higher unemployment to cause house prices to fall. And even then, the fall likely will be mild (10% from here?). 
 

We have a severe shortage of housing right now. Very low listings of homes for resale. Exceptionally low vacancy rate (around 1% i think). So the market is frozen right now. No one can move. (Rent increase for new tenants is running close to 20%; rent increase for existing tenant was 2% this year - as mandated by provincial government - after a 1.5% increase in 2022.)

 

Canada also had about 1 million immigrants come in over the last year: international students, foreign workers and regular immigration. Most want to live in Toronto or Vancouver.

 

Cost to build a condo in Vancouver is C$1,100-$1,200 a square foot. For a 2 bedroom 850 square foot apartment that is $1 million. Interest costs for builders is spiking so this cost is likely too low. About 1/3 of a builders costs today are now taxes (municipal, provincial, federal) - all levels of government need housing to chug along.

 

Bottom line, the real estate market is Vancouver and Toronto is NUTS. It is completely warped out of shape (like a pretzel).

 

The crazy thing is the housing boom has made millions of Canadians millionaires. It has also become a cultural thing… want to get rich? Buy real estate. It is everywhere in society. Hockey is no longer Canada’s pastime - it is now real estate.

 

At the end of the day, i am watching real estate closely. I have three kids, the first of who just graduated from university. I would love for all three to live in Vancouver (we all like each other…). If they don’t live in Vancouver it will likely be Toronto (the center of the world for employment in Canada). 

 

Anecdotally, I think the pandemic and work-from-home are starting to blunt the need for real estate in Toronto/Vancouver. I've turned over 3 rental condos in Calgary in the last year, and 2 of the tenants are people who moved from the Lower Mainland. Only one the prior year, which was also from the lower mainland. Stated reasons for all 3 were the cost of housing* - in all cases they paid me large rental rate hikes over what I was charging the previous tenant, but are paying much less than they were paying previously in BC (previous rent/landlord is on my application form, and I verify it). If real estate in Calgary becomes a substitute for real estate in Vancouver even at the margins that has the potential to hurt that market, as it's a LOT cheaper here. We also just had some friends move here from Abbotsford. They are from the UK originally and immigrated to Vancouver, and cashed out their gains on a townhouse to buy a large detached house here for cash. They have 3 kids, so the change from a 1500 square foot townhouse to 2500 square foot detached will be welcome I suspect. 

 

*one also mentioned that she thought Calgary was safer than Vancouver as an equal factor to the cost savings. 

[SharperDingaan]

Agreed re Vancouver/Toronto. Toronto supply remains tight primarily because boomers aren't downsizing, newer buyers are being propped up by family, and most all new builds were pre-sold before they came to market. While higher interest rates is pushing some property into the market, it is primarily going to the 1st quartile of new immigrants. Where owners of new builds weren't able to maintain commitments (common), construction of the new build just wasn't initiated. The tipping point will be when the Air B&B landlords are forced to sell their empires; a while yet.  

 

Thing is, it's also a very narrow market, Calgary and Edmonton are quite a bit different. Nothing prevents a 'partnership' buying a house there, and renting it out; kids on the property ladder early, using the various tax plans available  Should o/g came back at some point, and Alberta booms again, so does the value of the house. Obviously, property is mostly a 'mind-set' thing; but keeping an 'open mind' could take you a long way.

 

We hold our 'cash' in T-Bills, UBS/CS, and BTC; we're also aggressive, so not for everyone.

Look at the Purpose ETF's and their ETF options on the Montreal Exchange 

 

SD  

Edited June 9, 2023 by SharperDingaan

[John Hjorth]

Thank you for reminding us of that special circumstance related to foreign persons immigrating to Canada, who have capital with them at entry. I understand it as a fact provided to me, but I have never really understood how this was even possible. Are there mountains of cash laying around under pillows and in mattresses in the city of Vancouver? [Great place to pursue a carrieer  as burglar then.]

 

Aren't there 'Known Your Client' [KYC] procedures in place, and 'Anti Money Laudering' [AML] counter measures in place in Canadian banks?

 

- - - o 0 o - - -

 

Here to me, these things have gone crazy here locally, it has become a monster and a nightmare in the administrative  load on any Danish bank. No judgement based on KYC and some kind of trust - just totaly following some internal rules by their mechanics according to work - not guideline - more an order. So much for what has happened in DANSKE.

Edited June 9, 2023 by John Hjorth

[ICUMD]

Canadian banks are pretty sound I think given their oligopoly and with new immigrants entering the banking system. 

 

What is more interesting to me is whether the thesis of structurally higher interest rates is correct or not. Inflation is high and a lot of debt/ asset is held in the form of mortgages.  Many of these mortgages will reset in the next 3-5 yrs. 

 

This could 'deflate' the housing market. Perhaps this is the true intent of the BOC.

 

 

[ICUMD]

10 minutes ago, John Hjorth said:

Thank you for reminding us of that special circumstance related to foreign persons immigrating to Canada, who have capital with them at entry. I understand it as a fact provided to me, but I have never really understood how this was even possible. Are there mountains of cash laying around under pillows and in mattresses in the city of Vancouver? [Great place to pursue a carrieer  as burglar then.]

 

Aren't there 'Known Your Client' [KYC] procedures in place, and 'Anti Money Laudering' [AML] counter measures in place in Canadian banks?

Canadian banks are known for their soundness and their presence in tax havens like the Caymen Islands.  Would not be surprised to find out they own Laundrymats. 

[John Hjorth]

Thank you, @ICUMD,

 

That was the bit of information, that I was missing to understand.

[Viking]

1 hour ago, ICUMD said:

Canadian banks are pretty sound I think given their oligopoly and with new immigrants entering the banking system. 

 

What is more interesting to me is whether the thesis of structurally higher interest rates is correct or not. Inflation is high and a lot of debt/ asset is held in the form of mortgages.  Many of these mortgages will reset in the next 3-5 yrs. 

 

This could 'deflate' the housing market. Perhaps this is the true intent of the BOC.

About 66% (2/3) of Canadians own their primary residence and 33% rent. 
 

40% of all Canadian home owners carry no mortgage on their property. 50% of Vancouver home owners carry no mortgage. So higher interest rates have little impact for these people.

 

And of the 60% who carry a mortgage a mortgage probably 2/3 of this group have likely owned for 10 years so their mortgage is very small. Here rising interest rates matter some.

 

So my guess is 20% of Canadian home owners are likely stressed by the increase in interest rates. Some of these will have fixed rate mortgages (5 year fixed being the most popular) so it will take a few years for higher rates to fully impact even this group. 
 

If i am close, that means 13% of Canadians (20% x 66%) are feeling the heat of higher rates (via their mortgage). My guess is some of these people will get help from their parents (who are sitting on significant wealth). This might explain a little why higher interest rates is not having its usual impact in slowing economic activity.
—————

Oh, and lets not forget about savers. My 91 year old mother in law is now earning 4.5% to 5% on her GIC’s, up from zero 18 short months ago. This is a material increase for her. And she is spending her newfound source of income. Lots of seniors out there in the same boat. 
 

And let’s not forget about all those Canadians who are sitting on enormous real estate gains, many of whom are mortgage free. Add in pensions. A decade of stock and bond market gains. That is an enormous amount of wealth that is impacting spending patterns - and it is largely insensitive to interest rates. Do they care if your restaurant bill went up 10%? Does it change their behaviour? Nope. 
 

Bottom line, the Bank of Canada is slowly learning that the old models need to be updated… 

[ICUMD]

7 minutes ago, Viking said:

And let’s not forget about all those Canadians who are sitting on enormous real estate gains, many of whom are mortgage free. Add in pensions. A decade of stock and bond market gains. That is an enormous amount of wealth that is impacting spending patterns - and it is largely insensitive to interest rates. Do they care if your restaurant bill went up 10%? Does it change their behaviour? Nope. 

 

Bottom line, the Bank of Canada is slowly learning that the old models need to be updated… 

May suggest that there are quite a few more rate hikes coming down the pipeline.  8-10% interest rate could become a reality. 

[Viking]

2 hours ago, bizaro86 said:

*one also mentioned that she thought Calgary was safer than Vancouver as an equal factor to the cost savings. 

@bizaro86 Parts of Vancouver are really in decline; Chinatown being an easy current example. Tent cities have popped up everywhere (not just a Vancouver thing… i saw it even in rural BC) - and it has now become a way of life for many. Catch and release is looking like a disaster; especially when mental illness is involved. The Provincial government is using BC as a test kitchen when it comes to drug use/treatment in general and i am not sure the reality on the ground is going to live up to the theory in the study. My read is we are reaching a tipping point where it is going to become an important factor at the polls. Vancouver just had a civic election and a right of center party swept the slate (extremely rare occurrence). Voters are getting pissed off. 

B.C.’s drug decriminalization experiment is off to disastrous start

- https://www.theglobeandmail.com/opinion/article-bcs-drug-decriminalization-experiment-is-off-to-disastrous-start/

 

Edited June 9, 2023 by Viking

[ICUMD]

26 minutes ago, Viking said:

@bizaro86 Parts of Vancouver are really in decline; Chinatown being an easy current example. Tent cities have popped up everywhere (not just a Vancouver thing… i saw it even in rural BC) - and it has now become a way of life for many. Catch and release is looking like a disaster; especially when mental illness is involved. The Provincial government is using BC as a test kitchen when it comes to drug use/treatment in general and i am not sure the reality on the ground is going to live up to the theory in the study. My read is we are reaching a tipping point where it is going to become an important factor at the polls. Vancouver just had a civic election and a right of center party swept the slate (extremely rare occurrence). Voters are getting pissed off. 

B.C.’s drug decriminalization experiment is off to disastrous start

- https://www.theglobeandmail.com/opinion/article-bcs-drug-decriminalization-experiment-is-off-to-disastrous-start/

 

Decriminalization of drugs is a terrible idea. Humans and esp kids have a curious nature and a significant subset of these drug experimentors will become full blown addicts. I've seen this first hand. 

 

Legalizing highly addictive substances only increases proliferation and uptake.

 

Treatment centers while fine in an of themselves, do not target prevention which is the mainstay of any public health initiative.  

 

Rather, there needs to be harsh penalties for the dealers ensnaring kids and young adult. Supply chains of illicit drugs need to be broken.  

 

A terrible thing to see promising lives lost in this way.

 

[SharperDingaan]

24 minutes ago, Viking said:

If i am close, that means 13% of Canadians (20% x 66%) are feeling the heat of higher rates (via their mortgage). My guess is some of these people will get help from their parents (who are sitting on significant wealth). This might explain a little why higher interest rates is not having its usual impact in slowing economic activity.
—————

Oh, and lets not forget about savers. My 91 year old mother in law is now earning 4.5% to 5% on her GIC’s, up from zero 18 short months ago. This is a material increase for her. And she is spending her newfound source of income. Lots of seniors out there in the same boat. 

 

Bottom line, the Bank of Canada is slowly learning that the old models need to be updated… 

 

A good chunk of that 13% is the Air B&B crowd; multiple properties cross-mortgaged against each other, running a negative carry every month, that is financed via a HELOC. More than a few were also laundromats; all else equal if they are not refinanced, when the mortgages are eventually called in, multiple houses will hit the market at the same time. Probably high-up on the BoC wish list.

 

Most GIC's are now paying 3-4x what they were even 18 months ago; and at times it's often worthwhile to cash-in the old low rate GICs, pay the penalty, and reinvest in new high rate GIC's. Yield chasing not only diminishes, it gives the BoC a lot of extra 'security' as well (domestic income spent domestically). Of course if you're an analyst/reporter with < 10 years experience, this is all brand new to you! Opportunities to play the 'spin'     

 

The only 'structural' thing here is yield curves, returning to their historic term premium and normal shape; to get there is a matter of draining liquidity overall (raise the curve), and draining in the longer term faster than in the shorter term (raise term premium). The mystery is how soon, and how fast ....  look to how many of the big borrowers have been terming debt out, and trying to borrow whatever they can  

 

Over the long-term, Toronto/Vancouver continues to gentrify, those who can't afford it move out, and we have hybrid work from home as a routine thing. 'Go' buses/trains move over to hybrid and full electrification; public transit networks branch out from rail lines, and improve connectivity/reliability. Via Rail electrifies from Windsor through Quebec City, and becomes part of upgraded electric grid. The middle-aged with kids move to the 'burbs, the 'aged' and the 'young' move downtown as costs come back down. Not a lot different than it is in most other global cities.

 

SD

 

[Spooky]

1 hour ago, ICUMD said:

May suggest that there are quite a few more rate hikes coming down the pipeline.  8-10% interest rate could become a reality. 

 

Raising interest rates is not going to solve the problems of higher inflation through geo political tensions / near shoring etc. How long are we going to outsource decision making to the central banks? It seems to me like we need to identify which parts of inflation are a problem and have a government policy response to address it.

 

On housing, I find the Canadian government's policies to try and address the problem laughable.

[Spekulatius]

It all depend on what the US Fed is doing. All the other central banks are more or less just following the Fed, they just have to. If they don’t and the Fed raises rates, their currency will get trashed.

It’s especially true for Canada, because their economy is so closely tied to the US economy.

[Viking]

1 hour ago, Spekulatius said:

It all depend on what the US Fed is doing. All the other central banks are more or less just following the Fed, they just have to. If they don’t and the Fed raises rates, their currency will get trashed.

It’s especially true for Canada, because their economy is so closely tied to the US economy.

@Spekulatius at the end of the day, what the Fed does will impact Canadian inflation in a big way. But the Bank of Canada also has an important role to play (feels kind of strange to write that). The Bank of Canada was already on pause (since January). There was only one reason for them to hike this week… and it had little to do with the Fed. Or the Canadian dollar. High inflation (4%ish) is starting to get entrenched as the new normal here. I think the tipping point was the strong rebound in the resale housing market since January (they paused and housing took off).
 

i am beginning to think there is only one thing that is going to get inflation under control - and that is a recession. My guess is the US is in the same boat. Central banks are going to have to chose. I was surprised the Bank of Canada increase rates - with their premature pause in January i thought they had already made the decision to let inflation run at 4% for a few years (that is how you solve a too much debt problem). It looks like i might be wrong - and the Bank of Canada just might be coming to the conclusion they need a recession - and higher unemployment - to get inflation all the way back down to their 2% target.

—————

A big problem the Bank of Canada has is they only control the monetary side of the equation. As i posted earlier, the federal government and some of the provincial governments are spending like drunken sailors. So the fiscal response is highly stimulative today. At the same time the government is bringing in a record number of foreign students/foreign workers/immigrants and that is also highly stimulative to the Canadian economy. So we have this crazy set up where monetary and fiscal policies are working at cross purposes. So i am very interested to see where we go from here… the Bank of Canada might need to hike a few more times. If they keep going they will get a recession at some point.
————-

I am looking forward to seeing what the Fed does next week and, perhaps more importantly, what their communication is. I wonder if they learn the lesson of Canada and Australia - a pause is just an illusion. It simply gives inflation more time to work its dark magic on the economy. The last thing the Fed needs is a rebound in US housing and the stock market taking off - which is probably what happens if they pause.

Edited June 10, 2023 by Viking

[Spooky]

It's true, the Bank of Canada announcing a pause led many to jump back into the real estate market in Toronto with renewed FOMO.