February 26, 2021 | The Reset?

Don’t mess with the bond market.

This omniscient blog has told you for weeks the Covid-created crazy-low interest thing wouldn’t last. Now we know. In the last few days economic, virus and vaccine news resulted in a “flash spike” in rates that will ripple through portfolios, mortgages and real estate.

The yield on a benchmark Government of Canada five-year bond has soared form the 0.3% range to almost 1%. It hasn’t moved this much, this fast, for a decade and doubled in about two weeks. In the States the 10-year Treasury bolted higher to 1.6% and probably won’t stop there.

So, why?

As you know, when the slimy little pathogen slithered into our lives a year ago the economy panicked, lockdowns happened, politicians freaked and central bankers rode to the rescue. They crashed their benchmark lending rates (sending mortgages spiralling lower) and started big QE programs. That stands for ‘quantitative easing’, a fancy way of spending giant heaps of money buying up government bonds in order to suppress rates. The goal was to make money so cheap people would – despite the virus – borrow and spend a lot, adding to economic activity.

It worked. Along with the unprecedented amount thrown around by governments (like Trudeau’s CERB billions), this encouraged people to start overpaying for houses and taking on epic real estate debt.

Now everything has changed. Infections, hospitalizations and deaths are receding. There are a bevy of effective vaccines (we just added AstraZeneca). We’re engaged in a global inoculation program and on our way to herd immunity. Personal savings rates have exploded thanks to WFH and benefit payments. Governments around the world have ponied up $20 trillion in stimulus money. And it’s become clear that GDP growth will be explosive in the second half of 2021, leading to oodles of inflation. On top of this there’s a spendy new US government in place, about to pump another $2 trillion into the GDP and (if possible) dramatically goose minimum wages.

So all this has overwhelmed CB efforts to keep rates low. Smelling inflation, bond investors demanded higher premiums. So bond prices have been falling and yields rising.

The implications are legion.

For example, stocks have been pushed lower as bonds returns go higher. Money flows from ‘risk’ assets into safer ones as the bond yields pose serious competition to corporate dividends. That’s why the higher-flying equity markets have taken a gut punch. Especially tech companies, which rely on a lot of cheap money and big leverage to develop and take risks. Think Tesla.

There’s also a rotation happening into areas that will benefit from the reopening of the economy, and away from the WFH companies. Like oil, as people start driving more and industrial consumption rises. Also keep an eye on the banks. If the bond guys are right, inflationary pressures will force central banks to raise rates a lot sooner than most people suspect. So better margins are on the way.

And lots coming for real estate lending. Bond rates are now back at pre-Covid levels, yet mortgages remain close to the lowest levels ever. Not for long. When will the big banks inflate rates? “We’ll likely see a fat price adjustment from them soon,” says broker Rob McLister. “And after 11 months of declining rates, countless borrowers will see that, get butterflies and scramble to lock in. In the meantime, the lowest fixed rates are still less than 5 bps from their all-time lows. That will not last.” (Actually on Friday afternoon TD was the first to move – adding a quarter point. Pow.)

The impact on housing?

Well, usually when rates start to jump, so do buyers. Folks sitting on the fence climb off fast, lock in, then shop hard to find a property. Given the spring market is fast approaching, that’s likely to pour a more gas on the fire. But with prices having escalated irrationally during the pandemic, especially in the hinterland (Muskoka is up 60% year/year, for example) the universe of potential buyers is shrinking fast. As fixed-rate mortgages plump, it will decrease further. You know what happens next.

Where from here?

Central banks could jack up their bond-buying to try and stifle rates. That might work for a while, but the relief would be temporary given the vaccine/reopening momentum. Governments might scale back on their plans for even more stimulus, but it looks like Biden and Mr. Socks are determined to keep the taps open fully.

So everything tilts. Stocks find a new pricing. Fixed income assets get a shake. Borrowers face a reckoning. Housing confronts a test.

It’s worth remembering some of this things we’ve told you to watch for, and do. Like be diversified and own ETFs with broad market exposure instead of trying to luck out with tech stocks or WFH companies. That approach would have helped a ton this week. Also, own preferreds. Rate reset prefs become more valuable as rates rise, and they’ve been doing exactly that. This offsets fading bond values in the FI portion of your portfolio. Also those who thought one balanced fund, like VBAL, was an easy way to achieve a balanced portfolio just learned a hard lesson. Nobody should have 40% bonds. Now you know why.

And let’s hope if you didn’t lock in your mortgage (as instructed) that you’ll still have the chance next week. Hey, maybe you should stop reading now, and call.

So, you see? This blog may actually be worth what you pay for it.

Garth Turner February 26th, 2021

Posted In: The Greater Fool

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