Martin Pelletier
Financial Post
Bank of Canada governor Mark Carney has been warning consumers for some time not to get too comfortable, since higher interest rates are on the horizon. We think this is more of a scare tactic to get overleveraged consumers to rein in their borrowing levels, because Canada is certainly not on solid enough footing economically to raise interest rates, at least not until its trade partners do.
The problem is many Canadians aren’t listening, They’re partying like its 1999, taking on vast amounts of debt because of low interest rates and robust housing prices. While the level of household debt to GDP is falling in the U.S., it’s been increasing in Canada and now stands at more than 93%.
Consumers in the U.S. have been deleveraging since the 2007 collapse of their housing market. Perhaps this is because many don’t have a choice given the large drop in asset values, primarily housing. The Survey of Consumer Finances points out that U.S. households experienced a whopping 39% drop in their median net worth to US$77,300 in 2010 from US$126,400 in 2007, wiping out 18 years of gains in the process.
The U.S. Federal Reserve has responded by reducing interest rates to near zero and running the money printing presses 24-7. However, all this money supply has been sucked up with little impact on velocity — the rate at which money is used for purchasing goods and services — so there has been limited flow through to the consumer.
Since slightly more than one-third of U.S. house owners are underwater on their mortgages, consumers have had no choice but to deleverage. Total U.S. domestic debt as a share of the economy has declined for the past 12 consecutive quarters, MarketWatch reports, and the ratio of total debt to gross domestic product has fallen to 3.36 from 3.73.
As a result, U.S. household debt to GDP has significantly improved, falling to 84% from its peak of 98%. Some of the research we’ve seen shows that economic growth becomes impaired whenever this ratio surpasses 85%, so the U.S. is certainly cleaning up its act.
It’s a different story in Canada, though, and we think this is why Mr. Carney is concerned. We believe the catalyst for deleveraging to begin in Canada won’t likely come from a U.S.-style housing collapse given our country’s more prudent lending standards. That said, there are some markets such as Toronto and Vancouver that have seen a flood of direct foreign investment that, if curtailed, could result in a pricing pullback. Combine this with higher interest rates and there is likely going to be some trouble ahead.
We have expressed concerns in the past about how higher rates pose a risk that many bond investors have not considered. How many investors in 10-year Government of Canada bonds know that if interest rates were to double to 4%, the value of these bonds will fall by nearly 15%?
But there is another way to play this. The prudent investment for Canadians with a floating-rate mortgage is to take any extra savings and apply it to the principle.
For example, assuming one is paying the prime interest rate, which is currently 3%, a before-tax, risk-free investment would have to yield approximately 5% to offer the same return as paying down a mortgage.
By paying down their mortgages, investors will also be in a much better position to take advantage of the market when rates eventually revert to higher levels.
Overall, we don’t think this will happen for some time yet, perhaps another year or two at the earliest, so this is a trade that still has some legs to it.