January 26, 2023 | Tightening Will Continue To Bite Through 2023/2024

As we’ve noted many times, changes in monetary policy—tightening or loosening—move through the economy at a lag of one to two years. For this reason, the record tightening done by central banks in 2022/2023 will slow the economy into 2024, and any easing efforts in late 2023/24 will not fully be felt until 2024/2025. In the meantime, a whole lot of credit stress is compounding.

Yesterday, the Bank of Canada (BOC) hiked the overnight rate to 4.5% and said it would pause (but continue quantitative tightening ‘QT’) to allow the rate shock of the last ten months to work its way through the economy. Canada’s commercial prime interest rate moved to 6.7%, variable rate mortgages 6%+ (from sub 2% last March) and home equity lines of credit (HELOCs) 7.2% (from 2.95% ten months ago).

The rate of change in borrowing costs has been extreme, but the bigger problem remains grossly inflated prices. Doubling in popular regions between 2016 and 2022, including a manic 50% jump between 2020 and 2022, the average Canadian home sale price was $626,318 in December, down 12% year over year and -14% since February 2022.

Now the BOC and major banks expect a greater than 20% peak-to-trough drop in home prices nationally by the end of this year. That would be a mild outcome historically. Some previous hot spots in Ontario and BC have seen their sale prices fall more than 20% but remain 20% above 2019.

In Canada’s last two housing busts, starting in 1981 and 1989, prices corrected an average of 30% nationally, peak-to-trough, over 4 and 6 years and did not recover the prior highs for years after the troughs. Recessions with job losses and a credit default cycle accompanied prior realty-led downturns.

A 2018 Bank of International Settlements (BIS) study found contracting real estate investment typically triggers a recession within two years and falling property prices for an average of 4 years. So far, we’re one year into this downcycle.

The US Conference Board Leading Economic Index has been negative for ten consecutive months, which has never happened outside of a recession.

Equity markets historically fall more than 30% during recessions. They don’t bottom until near the end of the economic contraction when short-term rates have been cut for months and enough to re-steepen the yield curve to positive sloping once more.

Central banks are still tightening today, and yield curves remain deeply inverted globally. If the US Fed follows the BOC in a pause at their meeting in February or March, the first rate cut typically comes about five months after the pause. The bond market is presently pricing 200 basis points of cuts between July 2023 and January 2025.

Valuable investment opportunities for risk assets will likely present in that time frame. It’s not possible, or necessary, to time cycles perfectly, but it is important to anticipate them enough to be prepared.

Danielle Park January 26th, 2023

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