The Blubber

Canada is beating the U.S. into a recession, per the Globe and Mail.

Canada's economic situation is approaching, if not already in, a recession. The impact of higher interest rates is making its way through the nation's overextended real estate sector and highly leveraged financial system. Coupled with its significant exposure to global demand and a fragile domestic consumer, Canada's economy is cooling more rapidly than its neighbor to the south.

The critical question now is the depth and severity of the recession. As it teeters on the edge of a substantial deleveraging process, the Bank of Canada faces the risk of maintaining interest rates at elevated levels for too long in its pursuit of managing inflation. This could potentially transform a recession into a full-blown crisis. We anticipate that the Bank of Canada will need to ease financial conditions ahead of the U.S. Federal Reserve. Therefore, Canadian government bonds are appealing in both relative and absolute terms, while the Canadian dollar appears poised to weaken.

The substantial surge in interest rates and the tightening of financial conditions seen in 2023 are global trends, but Canada seems to be among the first to exhibit clear signs of their impact on the real economy. Following a 0.2 percent annualized contraction of GDP in the second quarter, Canada is just one quarter away from meeting the common definition of a technical recession. However, considering the slowing business activity, sentiment, and pricing pressures, coupled with potential data revisions, it's entirely plausible that Canada is already in a recession.

The national accounts figures are more concerning than the headline expenditure growth rate might indicate. When GDP is adjusted for immigration, which contributes to overall expenditure but does not reflect underlying growth in economic capacity, it suggests a recession is already underway, with GDP per capita experiencing a 1.7 percent year-over-year decline. Real gross domestic income is already in recessionary territory, having decreased for four consecutive quarters, down 3.9 percent year over year as of the second quarter. The non-residential private capital stock, responsible for investment assets like machinery and factories, has essentially stopped growing since 2015, and real business investment has regressed to levels seen five years ago. Beneath all these trends lies a concerning decline in productivity, which has been stagnant for the past five years and decreased since the first quarter of 2022.

This could be attributed to the swifter interest rate transmission mechanism in Canada, where mortgages have a shorter duration before they reset. Roughly two-thirds of Canadian mortgages have fixed rates on three- or five-year contracts, meaning the peak impact of cumulative rate hikes occurs two to three years after the beginning of the cycle. These lags are considerably shorter than those in countries such as the United States, where homebuyers secure historically low rates for 30 years.

To address the impact of surging mortgage rates they've passed on to customers, Canadian banks have permitted borrowers to avoid unaffordable increases in monthly payments by extending their loan terms and increasing the interest portion of their debt. This has pushed the proportion of loans at major banks with 30-plus year amortizations to 24 percent, while 40-year amortizations for new mortgages have become commonplace. The negative amortization rate, indicating the share of mortgages with installments insufficient to cover interest charges and increasing the overall balance, has reached an unsustainable 20 percent.

This leniency from banks explains why mortgage defaults have not seen a significant increase. (In fact, arrears are close to historic lows.) However, delaying defaults does not eliminate the risk, and significant threats are mounting within the financial system. Banks are preparing for the inevitability of growing consumer stress by significantly increasing their reserves for defaults. Concurrently, real estate prices are starting to decline as supply surges onto the market due to deteriorating mortgage affordability.

Considering that the Bank of Canada has been raising interest rates in the context of the most indebted consumer economy in Canada's history, with the household debt-to-disposable-income ratio exceeding 180 percent at the beginning of the cycle, the deleveraging process now underway will exert a considerable drag on the economy. In light of increasing debt burdens and waning confidence, it's unsurprising that consumers anticipate reducing real expenditures over the next 12 months. This will directly hinder GDP growth and sustain the recession.