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House of Cards - Views from the North

FICC Podcasts 28 juillet 2022
FICC Podcasts 28 juillet 2022

 

Disponible en anglais seulement

In this episode, Robert Kavcic, a Senior Economist from the BMO Economics team, joins me for an update on his thoughts on the Canadian housing market amid aggressive Bank of Canada rate hikes, and his views on the economic and fiscal backdrop for the Canadian provinces.


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About Views from the North

BMO’s Canadian Rates Strategist, Ben Reitzes hosts roundtable discussions offering perspectives from strategy, sales and trading on the Canadian rates market and the macroeconomy. 

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Disponible en anglais seulement

Ben Reitzes:

Welcome to Views from the North, a Canadian Rates and Macro Podcast. This week, I'm joined by Robert Kavcic, a Senior Economist from the BMO Economics team. This week's episode is titled 'house of cards.' I'm Ben Reitzes, and welcome to Views from the North. Each episode, I will be joined by members of BMO's FICC sales and trading desk to bring you perspectives on the Canadian rates market and the macro economy.

Ben Reitzes:

We strive to keep this show as interactive as possible by responding directly to questions submitted by our listeners and clients. We value your feedback so, please don't hesitate to reach out with any topics you'd like to hear about. I can be found on Bloomberg or via email at benjamin.reitzes@bmo.com. That's Benjamin.reitzes@bmo.com. Your input is valued and greatly appreciated. Rob, welcome back to the show. It's been four months, almost exactly, since we had you on. And housing was the topic de jure then, and that is exactly why I've brought you back on today. So, welcome back and I'm hoping you can enlighten us as to what exactly is going on in the housing market.

Robert Kavcic:

I will try. Thanks for having me back, Ben.

Ben Reitzes:

I have faith, you can do it. So since March prices, I think almost to the day that we recorded, pretty much peaked at that time. So depending on where in the country you were at February or March, if you scroll through the cities on the MLS Home Price Index, that appears to be the peak for most places. And since then, it's been a one way trip lower as we clearly warned and rates have ramped up even faster than we thought at the time. And I think that's clearly playing an important role and we'll continue to do so. So can you give us a lay of the land here? Where are we in the decline? This is just the first innings here or are we nearing the end? How bad can things get? I guess we can kind of expand on that a little bit later, but why don't we start with just where we are for the market generally at the moment?

Robert Kavcic:

Yeah. So I would say its first innings, or even like the warm up round, right? Because so market peaked in March and it peaked literally after the Bank of Canada first tapped mortgage rates, first 25 basis point move, the market went cold instantly. And I mean, that kind of tells you what was going on in the market, right. There was just too much speculation, too much expectations of price gains and just a simple tap by the Bank of Canada stopped everything. So as of June, we were down, I mean, on the headline HPI, maybe like three to 5%. The reality is that by June, some of the markets were already down probably 10, 15% across parts of Ontario and some other parts of Canada and momentum is just through the middle of the year was clearly just getting weaker.

Robert Kavcic:

And the key here is that, this is all even before the Bank of Canada raised rates a 100 bps and we have another a 100 basis points are so priced in through the rest of this year. So we also know that monetary policy acts with a lag, call it 6, 8, 12 months in terms of the impact on something like housing and the overall economy. So you got to think that we're looking at probably right through 2023 in terms of how long this weakness in housing gets drawn out.

Ben Reitzes:

Well, that's not particularly optimistic. So early innings for the decline in prices here. And as you mentioned, it really does depend on where you are. I was scrolling through the cities this morning just to get a better idea of how much we've fallen from that February, March peak. And some cities were down, it is 10 to 15% already in three or four months, which is really something to fall at that pace. But I mean, as we've mentioned in the past, a lot of the demand was driven by the pandemic and the drive for more space and work from home and all that kind of stuff. And the bid to those cities, well, outside of Toronto and other major city centers just wasn't sustainable. And then the types of price increases you were getting were not sustainable.

Ben Reitzes:

And now, you're getting a reversal of that pretty quick. I guess, the hope is that they don't kind of spiral downward and create some kind of more nefarious cycle here. But it's clear that there's still a notable downside I'd love to go. One of our competitors came out this week and said, "peak to trough decline in prices." 14% was the number they used, and oddly precise, 14%. Why not 15? Why not 10? But 14. How far do you think down prices go peak to trough? And I know it really depends on the city and the national number really is just kind of an average of a lot of different things. But how far down do you think we go?

Robert Kavcic:

Yeah. Well, that's the key, right? The national number masks a lot of change below the surface. So I think technically, we have a 20% peak to trough decline nationally. So that would take us back to about very early 2021 levels, which kind of makes sense because I mean, very early in 2021 was actually when you and I both came out publicly and said, "we have a problem developing here. And if policy makers don't act, we're going to see a lot of froth built up in the market and there's going to be consequences on the back end of it." And now, unfortunately, even though we were right, unfortunate that it actually did play out that way, and now we have to deal with the consequences. So repricing the market back to early 2021 kind of makes sense, because at that point we could still mostly justify what was going on and that's a national level.

Robert Kavcic:

So, to your point here, I would say a national decline of 20% would actually be really big considering that you do have some markets like Atlanta, Canada, like a place like Calgary, where we might not see more than maybe a 5% decline. The other side of that is that, you're going to have areas like Southwestern Ontario. So excerpts of Toronto, like anything, one to two hours out that are already realistically down 15 or 20% and probably more coming. So, I mean, peak to trough some of those markets. I mean, you could easily be down 30 by the time this is done in some areas. And then there are a few of other bigger cities, like the Vancouvers and the Montreals that are kind of just scattered somewhere in the middle of those extremes, I think just based on where they are fundamentally.

Ben Reitzes:

Okay. So we are, I mean, still notable price declines coming for most of the country. And really, the focus will be where the increases were largest. But one thing that is different from last time we spoke is rates have increased significantly faster and are still expected to move higher as you mentioned. Is that going to be a problem for current homeowners? I mean, we know very simply that higher rates dampen the ability of buyers to put in aggressive bids, because you just can't afford as much given a higher mortgage rate. But are higher rates going to be an issue for people already in their houses? Maybe you can go through the structure of the mortgage market a little bit, because I know I just went through it, a tour of Europe and that was a question. Most people didn't really know much about the Canadian market. So maybe a very brief backdrop for the mortgage market generally. And how rate hikes, or how much rate hikes are going to impact current mortgage holders.

Robert Kavcic:

Sure. So I guess the first thing on rates here is on the incremental new buyer, just since we were talking about this peak of trough decline, right? The reason we have 20% peak to trough in our forecast, is it just the simple arithmetic of re-pricing a market from 1.5% Mortgage rates to 4.5 cuts about 25% off the price of the value LL to hold affordability constant. So there's that backdrop from an incremental new buyer, which is where we're probably going to see the biggest hit. And we're already seeing it on the ground as prices come down, because we just simply can't afford what we did at 1.5% up now in the 4% range, so there's that.

Robert Kavcic:

But to your question specifically for those already in the market, a lot really depends on when you bought. So if you bought before the last 12 months or so, you're probably still in positive equity. So it's not a major issue from that perspective. There are a lot of investors that piled in through 2021 and early 2022 that were cash flow negative, just given how the market was priced and we're banking on price increases. Those guys are going to have a pretty significant shock because now, the expectations of prices have changed. Month to month, the cash flow dynamics don't make sense anymore. So you're probably going to see some selling and some liquidating of some investment property over the next year or two, I would suspect. But from like a more macro perspective at the household level, there are a couple things going on. One is that, we actually saw a very big shift into variable rate mortgages through the pandemic just simply because five year fixed rates, which are historically the more popular option in Canada backed up first.

Robert Kavcic:

And a lot of the markets switched into variable also, is a little bit easier to pass the stress test at variable rates in the latter stages of the pandemic. So there is some payment shock coming there. The mortgage market in Canada is a little bit unique in that you take a variable rate mortgage, you actually, for the most part, and it varies bank to bank. It varies contract by contract, but you have a fixed payment. And what actually happens below the surface is the amortization gets extended as interest rates rise, payment doesn't necessarily rise right away. But there is a point where if you reach a point where monthly payments are no longer actually covering the interest and paying down principle, then you will actually see a trigger payment. And again, it varies mortgage by mortgage, but I would say that if the Bank of Canada does raise rates 75 bps in September, there will be a number of home buyers who took out mortgages at 1.5% that are going to start hitting those trigger rates.

Robert Kavcic:

And the impact's going to vary, obviously, depending on your contract, but it could be looking at least a couple 100 bucks a month in terms of increases there. And the other aspect of this is if you go back five years ago, when five year fixed rate mortgages were the most popular option, they were being taken out at around 2.5 to 3.5% or so. And so, as those start to come due in the latter half of this year and into 2023, we're going to be coming into a rate environment that is more like 4.5% or so to just plus or minus 50 bps, depending on where we are and what exact mortgage you're looking at. But still, that's a good 1 or 200 basis point shock coming into a new mortgage. And again, that's probably at least a couple 100 bucks a month in terms of payment increases. So that's, not enough to break the market. It's not going to create defaults because we've been stress tested. But it will almost certainly be a drag on consumer spending and confidence more broadly.

Ben Reitzes:

One thing, I think we should highlight is especially on the investment side, but I mean, really generally in the big cities given where home prices are is everyone's had to put 20% down. And so the prices have to fall pretty substantially for buyers to be underwater. So it really is very much the most recent buyers that would be under pressure, but even then they may not end up underwater at all. And unless they're really in some of those harder hit cities. And then, that goes for investors and then just kind of regular home buyers as well. So that's, definitely something to keep in mind. And the other aspect of it is, for folks, especially in, I think maybe in the big cities, especially, but you can also probably include investors. There's still a big cash pile in households bank accounts, upwards of 9% of GDP.

Ben Reitzes:

As of the end of the first quarter, we'll see what Q2 shows us in a little while, in a month. But that probably resides with kind of higher income folks. And those are the ones that would be taking out kind of the bigger mortgages, buying the bigger houses, making many of those investments. So that might just be an area while there will be stress from higher rates, there's probably some cushion there to absorb the higher costs from higher rates. But I think it's undoubtedly the investment side in particular, probably adds to some of the downward pressure on prices as people just don't see real estate, maybe as quite the same attractive investment, it was over the past 10 years or so.

Robert Kavcic:

Yeah. That all sounds right. And I think the one thing that comes up is at least in the conversations I have with clients and things like that is like, is this like the US, because in the US, we had, back in 08, 09, we had teaser rates and then those rates reset. And then we had a wave of defaults and for selling, it's just not like that. The way our mortgage market is structured. And you got to keep in mind that when we were borrowing at 1.5%, we were being stressed tested at around five and a quarter. And it's a good thing we were because we are coming into a world where we have around 5% mortgage rates.

Robert Kavcic:

But so from a capacity to pay and to service your mortgage perspective, in theory, we should be very well insulated here. So obviously it will chip into disposable purchasing power and we'll cut back on spending elsewhere, but it's not going to create a wave of default. And that's a big distinction that we have to make. Where there might be a little bit more risk if this tightening cycle actually weakens the job market as well. And then that's another layer of weakness, but just strictly from an interest rate perspective, we are actually pretty well insulated.

Ben Reitzes:

Yep. I think that's a good point. We'll see what the job market does. We'll see how high rates end up going here, because there's still plenty of uncertainty there. But I mean, you are going to get some probably meaningful pressure on consumption at least into the back half of the year again. Those pandemic era savings still being spent, lots of pent-up demand, this is the summer of revenge spending, be it on travel or dining out or whatever service type spending people want to do, it's very busy out there. The airports are packed, the train stations in Europe are packed. Restaurants hard to get a reservation in any pretty much anywhere, really. And so that's probably going to be the theme at least for another month.

Ben Reitzes:

We'll see what happens come labor day and after that, when home prices continue to decline, rates higher, a little bit more of a squeeze on people. We'll have another call it anywhere from 50 to a 100 basis points at the next meeting in September, we'll see what the bank does there, but rates are still moving higher from here. And so that just means even more pressure on households. And I think one thing that we should also mention is residential construction. And just the housing sector in general is 10% of GDP in Canada. And so that is going to be a source of persistent downside pressure for growth, at least for the next year, probably 18 months.

Ben Reitzes:

And you could see some seriously negative quarters, especially near term as home sales have really fallen very sharply. And I'm sure renovation type activity is not far behind. And for those out there listening that live in Canada, on the bright side, if you have any home renovation projects that you've been waiting for and couldn't get any labor or trades to do next year, we'll probably be a pretty good time for that as things should loosen that materially for better or worse.

Robert Kavcic:

So your last point on construction is interesting because, we've been conditioned to think that we need to build more and more in this country, right. But we actually already building as much as we physically can. And more, we're actually starting to hear now is because demand has broken so quickly that we're starting to see projects actually get canceled in the big cities. So you have possibly the pace of construction activity and new housing starts rolling over and softening a little bit. I mean, it won't be dramatic because we still have demographic demand, but coming off of the boil at least. Then, you're going to have renovation activity for sure pull back just simply because we pulled so much activity forward into the pandemic and you don't have the same kind of investment and flipping activity. And then of course like the actual transaction component that goes into GDP as well has completely fallen off so, that and I know it's built into our forecast already. But that's going to be a persistent headwind from residential investment, right through 2023.

Ben Reitzes:

Yeah. I may not have negative enough there. I think the risks are still on the downside for what we have penciled in. But you mentioned construction and hasn't the refrain from policy makers and other talking heads been that we just don't have enough houses, and there's a lack of supply? Given what's going on right now, how do you feel about that?

Robert Kavcic:

There's no better way to balance how to market than throw a recession on it, right. And it sucks, but we're going to find out pretty quickly that we are pretty well supplied, I think. I mean, we know that like a quarter of home buyers through the pandemic were buying second and third properties, right? So there's that aspect, that demand is gone. It's gone already and hence why you're already starting to see some of these projects get canceled. And then the other side of it is that, even if we did want to double the rate of construction, which is what policy makers and a lot of talking heads are talking about. We just physically can't because for the last couple years, we've been building right up at capacity in terms of just the number of units under construction in this country.

Robert Kavcic:

So number of units under constructions are record high. For the 25 plus population base, it's as high as it's ever been. We have next to no unemployment in construction. We have record vacancies and wage pressure and material cost pressures. You just physically can't build anymore. And builders know this and builders see both sides of the equation and the fact that they are pulling back on projects right now, as we speak, just highlights that they are seeing demand roll over, I think.

Ben Reitzes:

So that'll be the next question, I guess, I mean, you're seeing projects get canceled partially because of high cost because you're seeing sales flow, but are we going to see housing starts really pull back? I mean pre-pandemic, we were in the kind of low 200,000 ish per year. And before that we were in just to sub that for most of the past decade. And now we're kind of in the 250 plus thousand area for housing starts. Are we due to go back down toward 200,000 or is the 250 ish pace and higher units under construction? Is that going to persist thanks to strong immigration, still good demographics again, or are we going to see a pullback there? And then all that supply talk really was not well founded.

Robert Kavcic:

I think we'll see activity pullback. Like it starts in construction activity always do follow the demand side with like six to 12 months lag roughly, right. So I do think we'll see activity pull back 250, 260 on annual starts is pretty strong. And I think that's kind of been in response to some excess demand. But there is still demographic strength as we talk about all the time, we've been talking about it for years too, right. Where household formation is actually probably running at a little bit above 200,000 per year. So there is a floor there. And even, I mean, even if we do start to see activity moderate, it's not going to be something that's an exceptional drag that takes starts back down into the 150, 175 range. I think you do have physical support right there at around 200,000. And that's probably where we settle in a little bit above that.

Ben Reitzes:

I wonder if we get back down there, whether the narrative of a lack of supply starts to come back, but we'll see when we get there. And then, we'll see what policy makers and others have to say. Why don't we leave housing there? Since I have you on, and you are our provincial specialist. I would be neglecting my duties if I didn't ask about the provinces, because it's always good for listeners and for myself to get a little bit of an update. I mean, there haven't been any budgets since last time. I guess, we finished budget season since last time you were on, but no major changes. I guess, has the provincial landscape changed at all? Are commodity prices still providing a big boost to Alberta, Saskatchewan, Newfoundland, where should investors focus their attention? Do you have any favorite provinces? All of those things. Go.

Robert Kavcic:

Yeah, well, no, I wouldn't say too much has changed. If anything, like we've just seen just the reinforcement of how quickly the resource producing provinces are improving. And Alberta is like the poster child of this, where they actually did come out with public accounts. And last year they were already in surplus. And this year, we're probably, I mean, where oil prices are and the dollar and the differential are today. There's probably a good $10 billion or more of fiscal upside there. And they've been very conservative on their forecast. They've been very quiet about this, but they have a ton of money coming in to spend. And there is an election next spring so, I'm sure they're quietly figuring out what to do with all this money and how to best play this.

Robert Kavcic:

But from a fiscal perspective, remember kind of early mid stages of the pandemic. Alberta looked really bad and they were falling towards the back of the packet, a number of metrics. They are very quickly have moved back to the top of the list in terms of the budget projection and the debt level and debt service costs and the board requirements and all that kind of stuff. So, I mean, unfortunately, that's a pretty well-known story now, and it's probably mostly priced in, I mean, you follow the spread market pretty closely.

Ben Reitzes:

Yeah. Spreads are probably done unless, oil prices go back up and then move further up. It's hard to see Alberta performing particularly well. And at least not until risk markets start to improve a little bit. But for now that, I mean, they've come under a little bit of pressure recently, and then they've flattened out. I guess that the days of tightening versus Ontario appear to have stalled out, at least for now, we'll see what commodity prices do.

Robert Kavcic:

Yeah. Quebec's another one too that's kind of been flying under their radar because we haven't heard much from them on the fiscal front, but I suspect there's going to be a pretty big revenue upgrade coming there too. Like Quebec does publish monthly transaction numbers, and those have been tracking well above budget expectations too. So when we get an official fiscal update from them, either public accounts last year, or like a midyear update from them later on in the summer, those numbers, there are probably going to look quite a bit better. So those, I mean, that's really it. We've been a little bit more British and British Colombia. This isn't new. I mean, this is probably been over the last two years or so, just given some of the policy tack that the provincial government there, which is more of a left leaning, higher spending government. They've been boarding a lot more and running bigger deficits, projecting longer strings of deficits.

Robert Kavcic:

So that story hasn't really changed either. And Ontario looks, I mean, the Ontario for a long time was carrying quite a bit of room for upside. I think that's starting to fizzle away a little bit now, just because we're more bearish on Ontario relative to the rest of the country, in terms of incremental economic growth revisions, just given that the housing downturn is hitting hardest right here in Ontario. So they were coming kind of out of a position where they had a quite a bit of room to work with, but that's probably getting chiseled away a little bit now, too.

Ben Reitzes:

Okay. What about Manitoba? Because that historically for a while, they would trade in line or at least directionally in line with Alberta and Saskatchewan. And what's happened over the past kind of year or so, a little longer is Alberta's tightened a lot and performed nicely, Saskatchewan as well. And though to a lesser extent, but Manitoba has lagged notably. Is that a province where we could find some opportunity because they look cheap here? I think given what I believe are decent fiscal fundamentals.

Robert Kavcic:

Yeah. The fiscal fundamentals are decent. Economic fundamentals are solid. I would say, relative to Alberta and Saskatchewan, you're never going to get the same performance on the upside because you just don't have the same kind of leverage to something like oil. So it wouldn't make sense for Manitoba to be keeping pace with the strength in Alberta and Saskatchewan at this point, anyway. Relative to someone like say in Ontario, maybe it gets a little bit more compelling because if we are going into a week period for the economy where ground zero of the housing correction is going to be in Ontario, Manitoba is probably very insulated on the housing front.

Robert Kavcic:

And from an economic perspective, they are always like the lowest beta province in Canada when we go into weak economic periods, or if we go into recessions. So in terms of like a defensive trade, if that's the way the market starts going over the next little while, and we've already seen some of that. But if that's kind of like the big picture theme, then Manitoba starts to look pretty okay on a relative basis versus say in Ontario, or even a BC.

Ben Reitzes:

And arguably, if we're going into a recession or something like that, commodity prices probably suffer there as well. So it might even look good, it might even look good versus Alberta or somebody else along those lines. And any other big themes that they're expecting? When might we get some of these midyear updates? Are they would come in the summer or are they going to wait till the fall? Kind of like the federal government.

Robert Kavcic:

You do get summer updates, but they tend to be pretty full forecast updates would usually come in the fall, like in Q2 or for midyear for these guys. So that would typically be October, November. But, August you tend to get pretty decent updates from provinces like Alberta and Saskatchewan. So depending how they want to play, you might actually start to see some of these numbers put on paper from Alberta within the next month, or so. If not, for sure, mid-year October, November, you should get pretty full updates on the fiscal outlooks.

Ben Reitzes:

Okay. So I'll have to have you back in November and then we'll see what housing's doing by then. If we're down a percent a month over the next, what's at four months or so, I guess we'll have three months of data by then. So three to four months, we'll be down seven to 10% for nationally in seven to 10 months. And we'll see what the fiscal update brings by then and how the economy's performing. So, Rob, thanks for coming on. I very much appreciate it. And I look forward to having you back on again in a few months.

Robert Kavcic:

All right. Happy to do it anytime.

Ben Reitzes:

Thanks for listening to Views from the North, a Canadian Rates and Macro Podcast. I hope you'll join me again for another episode.

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Benjamin Reitzes Directeur général, spécialiste en stratégie – taux canadiens et macroéconomie
Robert Kavcic Directeur et économiste principal

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