In many ailments, when the fever breaks, we feel relief. That is certainly the opinion of the Bank of Canada, which commented in its latest Financial System Review that a rise in borrowing costs could produce a “healthy” slowdown in the housing market. An explosive increase in home prices has put the dream of owning a dwelling out of reach for an expanding number of Canadians and, for those that have entered the frenzied market in the last year, it has greatly increased the risk to household financial stability. More importantly, in the Bank of Canada’s eyes, it has raised the risk to Canadian financial stability.

 

As Ally and I have discussed, it was inevitable that the combined pressures from higher interest rates and inflated prices for non-discretionary goods was going to lead to weaker demand in many segments of the economy, and housing would be the hardest hit. Toronto has seen a decline in the average home price for three months in a row, as of May, and Montreal saw its first monthly decline in prices in a while.

 

 

New homes continue to fetch higher prices, as we saw in April, but the demand fade will hit this segment as well. Supply isn’t going to help either.  Housing starts in Canada have been on an upward trajectory since the start of the year as builders saw dollar signs from the continuous gains in home prices.  Building permits also spiked in April and came within a percentage-point of the record high reached in March 2021.

 

 

This enthusiasm in the residential construction arena has been based on the view that interest rates would not go up too much. That view might still have some credibility, but the horses are bolting. The minute home prices start drifting lower and people put off home purchases, the engine can stall quickly. Builders have already been facing pressures from limited labour supply (and higher wage costs) and supply constraints. The last thing they need now is to look at vacant lots prepped for foundations when buyers aren’t coming through the show home.

Housing is no different than retail. Demand strengthens and the shelves empty. Calls go out for more product and wholesalers lean on suppliers to get it. Factories ramp up (where they can) and inventories grow. Given the media attention to supply disruptions and lack of available goods, some may think that inventories have been depleted. In fact, the opposite is true.  Canadian wholesale inventories are at a record high of almost $80 billion.

 

 

So, what gives?  Well- basically, companies are scared that the “just in time” model of inventory control is too dangerous in a world of constant supply disruption.   This fear was around even before Putin stepped into Ukraine. China’s covid lockdown policies are part of it too; but it is more pervasive than that. People aren’t going back to work and businesses are holding back from investing capital in expanding operations. Case in point, crude oil futures are trading at just over $120/barrel – less than the $136 high of 2008 – but gasoline futures are trading at a record high of $4.27 / gallon. Refinery capacity hasn’t kept up with demand.

 

Okay, let’s get back to our housing market. As our builder friends will attest, regulations could be more accommodating in this country when it comes to creating housing stock, though labour and material costs have also made a dent in construction profitability. Still, supply has grown to meet growing demand. The risk is that demand may not materialize the way we thought. At the same time, homeowners might be more motivated to list their homes to try to capture a wave that is cresting.

 

 

This is going to be a bit of a cat and mouse game. Canadian existing home sales are already on the decline, and they fell over 12% in April. Excluding the plunge at the start of the pandemic, this was the largest one-month drop since the start of 2018.  Remember, sales are a combination of listings and buyers. At this stage, the downward pressure on sales appears to be coming from the buyside. The problem with this situation is that sellers become more motivated, and listings increase. In other words, the housing factory has pumped up inventories not just from new construction, but from existing dwellings. It’s hard not to see prices decline.

 

This is what Governor Tiff Macklem was getting at. A cooling down in home prices might not be a bad thing. The problem is that the debt associated with the valuation of the current housing stock doesn’t go down alongside the decrease in home prices. Meanwhile, the borrowing costs attached to that debt have gone up and this is why the Bank of Canada also said that people who bought homes recently were “more exposed” to a correction in the housing market. Buying high and taking a high mortgage at the start of a rising rate environment will always leave you exposed. Some will say this is only going to happen at the margin and that might be true, but there is a potential domino effect.

 

Let’s break this into two parts. First is the direct impact of cooler housing activity. Less home construction equals less demand for building materials, such as lumber.  The escalation in lumber prices, as a result of supply restrictions, created a demand destruction on its own – something we saw last summer, when lumber futures fell over 70%.  After a revival at the start of this year, which took prices close to those 2021 highs, we are down more than 60% yet again. This is without the impact of slower demand. The secondary effect is going to be felt by those retailers that sell you things that go into the home when it’s built, whether appliances or vinyl flooring. Think Home Depot and Lowes.

 

Okay, so this is sounding a tad dismal.  No one wants a housing correction or a consumer that hibernates in the cave and causes a recession. It doesn’t have to be that dismal though. A slowdown that doesn’t create a cyclical upturn in unemployment can defeat the beast that everyone and their uncle is trying to slay and that is high inflation. Canadian consumer price inflation is sitting at just under 7% and US inflation is above 8%. We expected inflation to moderate to the 4% area by the end of the year; but if we get a marked slowdown in housing and ancillary consumer spending, then this target will be easier to hit.

 

 

If inflation moderates, then the Bank of Canada might be able to take the foot off the brake and this notion is shared with the Fed watchers out there as well. Implicitly, we can think this is what Governor Macklem was saying between the lines when he said that a housing slowdown could be “healthy”. That might prompt the Bank to decelerate the pace of monetary tightening and, just maybe, we can avoid a hard landing created by Mr. Macklem and crew hiking rates too much. What exactly is too much?  That debate is going on as we speak. Does the Bank’s overnight rate target break the 1.75% cyclical peak before the pandemic? That looks like a given. Do we get back to the 4.5% peak before the Financial Crisis? I personally think you have better odds catching a Great White in Buckhorn Lake, at least for this go round.

 

If we are at the start of a true normalization of interest rates (aka the end of the bond bull market), then the only recent precedent we must go on is the movements since the last financial crisis. Canada did bolt from the pack after that episode and raised rates in 2010. In 2015 there was a partial step back. There might be a useful pattern in this. The premature tightening took the overnight rate to 1%. The cyclical increase took the rate to 1.75% before the pandemic – a 75% increase from the previous peak. If we repeated that, then the next peak would be somewhere between 2.5% and 2.75%.  I would argue that when rates hit these levels, the pressure on housing will intensify and a “soft landing” could turn into economic contraction.

 

For now, we still believe that markets have been sufficiently efficient to price in central bank policy actions to the point where real economic slowdown is being created by higher borrowing costs, inflation and reduced confidence. Ironically, this gives us a better near-term environment for risk assets than was presented to us back in April.  The situation is still fluid, and we won’t know whether Canada’s housing market is going to be “just right” or become downright cold in the months to come.

 

On behalf of the Pyle Group, have a wonderful weekend.   

Andrew

 

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These are the personal opinions of Andrew Pyle and the Pyle Group and may not necessarily reflect those of CIBC World Markets Inc.