A 40% interest rate? Ho, Ho, Doh!

Nothing will put a lump of coal in the stockings of retailers this year quite like seeing Christmas sales completely evaporate.

And the chill is now on.

Word came out yesterday that some US credit card firms are pushing up interest rates by as much as 7% ahead of Christmas - and that's in addition to some heavy increases already implemented.

For the likes of Capital One, it means some customers will be paying almost 40% interest on their Christmas gifts and January sale purchases unless they clear the balance on their cards.

Angry Capital One customers have been complaining in a forum on the consumer website moneysavingexpert.com.

One said: "My World Mastercard's old rate is 15.9% and its new rate is 23.9%. I told Capital One it's no better than legalised extortion. I've never missed a payment or paid late - what a way to treat customers."

Another said: "My Capital One Classic Visa's old rate was 30.04%, new rate 39.9%. I'll be closing my card."

Capital One's reponse: "Due to current market conditions, we have had to increase rates for some customers."

Yes Virginia, there is a Santa Claus. There just won't be any presents this year.

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American Graffiti

“The stability we've started to see in U.S. housing was likely a false calm before a bigger storm. There are millions of homeowners under threat of losing their homes in the next two years.”

This is the observation of Derek Holt, vice-president of economics for Scotia Capital.

It seems a record one in seven U.S. mortgages, or four million homeowners, were in foreclosure or at least one payment late in the third quarter.

Even more astonishing is that Americans with solid credit ratings comprised 33% of the quarter's foreclosures.

This is what happens when a huge surge of people default on their mortgages, and the wave of foreclosures causes a big drop in the value of real estate. It puts other homeowners in an 'underwater' position. Throw in the highest jobless rate in 26 years and suddenly its impossible for many homeowners to make their payments in the quarter.

Another Canadian watching the developments closely is Jennifer Lee, an economist at Bank of Montreal. Increased foreclosures among those with good credit is a problem in any recession, said Lee, but this time the increase comes after the subprime crisis forced millions from their homes and pushed prices down as much as 50% in some cities.

Not only are they losing their jobs and falling behind on loan payments, sharply lower prices mean they aren't able to simply sell their homes to pay off their banks.

“We can't say what is typical any more in the housing sector because we've never experienced anything like this,” she said. “People need to start working again, because when they do find work the first thing they do is get back on track with their mortgages. But, that isn't likely to happen soon.”

Most of these have five-year reset rates, and were issued at the height of the market's bubble. They start coming due in January.

Once again Scotiabank's Derek Holt makes a succinct observation. “You didn't have to prove a thing to get [a mortgage],” Mr. Holt said. “They haven't been a problem because they have such long fuses. But those fuses are just about done, and we're heading into entirely uncharted territory.”

It takes a long time for the housing story to play out. For the United States it started in 2006. The full effects won't really start to be seen until next year.

For Canada the writing is on the wall.

It will start with rising interest rates. The first to get caught up will be all those resetting 0/40 mortgages and the huge number of people who "bit off more than they could chew" in the Great Reflation Drive of 2009.

The problem is, too many dismiss the writing on the wall as nothing more than graffiti.

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Gold Observations

Last Thursday we talked about Gold and when I made a return to work this week after a multi-week absence, several colleagues were keen for my thoughts on the yellow metal.

With Gold leaping to yet another all-time high in early London trade on Wednesday (coming within 50¢ of $1150 an ounce), the 64 thousand dollar question becomes: is it a bubble that is about to burst or will Gold go higher?

So let's consider what's happening.

As was stressed last week, the real motivation for the movement to Gold is not as a hedge for inflation. The reality is that it performs that role very poorly.

The current move to gold around the world is a hedge against the mismanagement of the state - which at this time and place is the United States with it's world's reserve currency status.

We are currently witnessing perhaps the most profound paradigm shift in gold from the patterns seen over the last 20 years. During that time European monetary authorities sold the precious metal and Asian central banks accumulated official reserves in the form of US Treasuries.

But now that pattern is being turned on its head.

Currently, sales in Europe have slowed to a crawl and Asian banks have started swapping their dollars for gold.

GFMS, the London-based consultancy, estimates that over the past 20 years net sales from the official sector have run at an annual rate of about 400 tonnes - about 11% of the total supply. But the combination of slower sales in Europe and fresh gold purchases in Asia are set to cut the official sector's bullion net sales to about 50 tonnes this year, the lowest level since 1988.

The shift is important for the gold market on two fronts: the interest provides psychological support and, more important, caps a source of supply.

Things began to really pick up steam when the IMF approved the sale of 403.3 tonnes of gold back in September 2009. In a completely unexpected move, India was the official purchaser of 200 on those tonnes in October.

It is largely understood that India sold holdings of US Treasuries to make the purchase.

Next up came the central bank of Sri Lanka who purchased gold in the open market at market prices, another surprise move.

Now the IMF has announced that Mauritius' central bank bought gold at market prevailing prices on November 11 for about $71.1 million (US Dollars) in total. According to data from the London Bullion Market Association, gold was quoted on the afternoon "fixing" that day at USD 1,115.25 a troy ounce, a record high at that time.

Before the transaction, Mauritius - a tiny nation made up of islands in the Indian Ocean more than 1,000 kilometres off the East coast of Africa - held 1.9 tonnes of bullion - 3.2% of its total official foreign reserves - according to data from the mining industry-backed World Gold Council. The purchase more than doubles the reserves to 3.9 tonnes.

It's another brutal kick in the teeth to the concept of nation states storing their wealth in the in the security of US Treasuries.

Even Zimbabwe, which a year ago had hyperinflation running at 231 million percent annually, is now considering reintroducing its Zimbabwe dollar, but this time fully backed by assets, including gold.

With India, Sri Lanka and now Mauritius adding to their gold reserves – and with Zimbabwe looking to purchase gold, it is putting extreme pressure on the gold supply. "It is the sentiment that matters" and not the size, says VM analyst Gary Mead in the latest BNP Paribas Fortis Metals Monthly. "The bottom line is that the Gold Price rally has got everything going for it right now: Few official sector sellers, some official sector buyers, a low-interest rate environment, and a weak US currency. It's a perfect storm."

Included in that perfect storm are the following elements:

• Decreasing Gold Mine Production - Annual worldwide mine production of gold has decreased by 9.3% since 2001. Gold prices have nearly quadrupled since then, but more gold is not being produced because resources are being depleted and the quality of those resources is diminishing. When a discovery is made, it takes about 7-10 years to get a mine permitted and into production, making it difficult to quickly ramp up gold production.

• Investment Demand for Gold - Large institutional investors, such as hedge and pension funds, are making large allocations to gold and gold shares. Individual investors are also getting in on the action, with gold exchange-traded funds (ETFs) gaining influence. SPDR Gold Trust (NYSE: GLD), the largest physically backed ETF on the planet, is now the 6th biggest holder of gold bullion with more than 1000 tons. That is helping to facilitate and spread the ownership of gold by individuals. In fact, in the first half of 2009 investment demand for gold is up 150% over the first half of 2008, according to the World Gold Council.

• Asian Demand for Gold is Exploding - Asia, with its more than two and a half billion people, has a major impact on investment demand. Asians have a long-standing cultural affinity for gold as a store of wealth. India is the world’s largest gold consumer. For the last 50 years, until 2009, the Chinese government has forbidden its citizens from owning gold. But now China is encouraging its citizens to buy both gold and silver. Today, Chinese investors even have access to gold-linked checking accounts. As a result, demand for gold in mainland China is expected to triple in the next few years.

Gold’s price has increased every single year since 2001. In 2001 gold sat at $300 an ounce. It has risen now for eight consecutive years. Are we currently in the middle of a secular bull market for gold?

Bull markets typically last about 17 years and end with a mania stage where investors throw the concept of supply and demand out the window and frantically invest in gold. Analysts note that this pattern has repeated itself over the last hundred years of investment history.

More importantly, when adjusted for inflation, gold is nowhere near that highs it attained in the 1980s. Adjusted for inflation, gold should be at $2,000 an ounce.

And if these factors are going to place even more upward pressure on the metal than the 1980s did, it would suggest that we are about to see a major run up in gold prices.

The gold market is very small in relation to the currency, bond or stock markets, so when investors start to pile in, it could just send prices through the roof.

As a side note Jim Rogers, the renowned global commodities investor and author, said he doesn’t ever like to buy something making all time highs but he is not selling his gold. He believes Gold is going to go much higher in the course of the bull market. He also warned that it doesn’t mean it can’t go down 20% next year but during the course of the bull market it is going to go much higher and whatever you are seeing is not a bubble yet.

Jim also said that being a contrarian, he should be selling gold when others are buying. But he hastens to add that he also sells at the top and that he doesn’t think this is the top.

“In my view, in this bull market in commodities gold will make all new highs adjust for inflation,” he said.

A possible coming drop of 20% in the price of Gold?

So my response to my colleagues was to read today's blog.

Like so much of everything we discuss here, the issue is all about confidence in the economy of the United States. You need to investigate that issue thoroughly and make decisions accordingly.

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Rationalization

Despite the fact that mainstream media, leading economists, bank presidents and the Governor of the Bank of Canada are now taking notice of the irrational way the Canadian housing market is 'reinflating', there are still those who vehemently seek to justify what is going on.

It doesn't matter that prices are hitting an all time high in the middle of the greatest recession since the 1930s. Nor that the current rate of double-digit price increases are coming amidst rising unemployment and within an economy that is otherwise contracting.

No... this isn't out of whack at all.

Certainly not to the likes of Bank of Montreal's Michael Gregory.

Gregory is adamant that there is no evidence that low interest rates are pumping a domestic housing bubble.

“The record surge in resale volumes reflects unleashing pent-up demand,” Mr. Gregory said in a research note. “From mid-2007 record highs (just before the global credit crisis began) to January lows, existing home sales plummeted 42%, with the majority of the decline occurring during the four months after Lehman Brothers' bankruptcy,” he wrote.

“Discretionary and big-ticket purchases of all types were postponed in the post-Lehman panic, creating an abnormal amount of pent-up demand... Once the panic subsided, pent-up demand started to unwind, pulled by record low mortgage rates, cheaper home prices (around 9% on average), and an emerging sense among consumers that the worst of the recession was over.”

Alrighty then. So it's a booming rebound and not a bubble then?

Douglas Porter, also with Bank of Montreal, concurs (surprise!).

“The rapid-fire rebound in Canadian housing is showing no signs of letting up,” Mr. Porter said in a note to clients. “While that may be causing some sweaty palms among bubble-phobes, the quick turn is a vivid illustration that monetary policy still works in this country.”

So here we are in the midst of a year when the average price of home resales rises by more than 20% despite the fact that overall inflation is sitting at less than 1%.

And these guys insist that it isn't a sign that something is dangerously wrong - but that it's just a reflection of 'effective monetary policy'?.

In psychology and logic, rationalization is the process of constructing a logical justification for a belief that was originally arrived at through a different mental process. It is a defense mechanism, in which perceived controversial activities are explained in a rational or logical manner to avoid the true explanation of the behavior in question.

And that's all this malarkey is... deceptive rationalization employed as a defense mechanism.

Have I said this is going to end badly?

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The Great Reflation

Scanning the worldwide news clippings today, the main topics of interest are Gold, the US Dollar and Interest Rates.

Early last night Gold spiked to $1,140 US per ounce and the Dollar index dropped well below 75.

In the wee hours of this morning, the Dollar index is back up and Gold hovers at $1,130.

We do live in interesting times.

The stock market was up again yesterday as US Federal Reserve Chairman Ben Bernanke gave no indication that he would take actions to back up his stated preference to promote the Dollar.

It seems almost unanimous that the market's recent upswing has all been about a weak dollar and ample liquidity.

But there seems to be a fine line being walked here.

"A steep slide in the dollar would be the death knell for the great reflation engineered by the Fed. But the Fed chairman's concerns about the currency's current level are not yet serious enough for him to abandon his interest-rate policy," said Jean-Baptiste Pethe of Exane BNP Paribas.

Ahh, yes... that's what they are calling it now. The Great Reflation.

It brings to mind this interesting quote from Benjamin Anderson, Chief Economist of Chase National Bank published in the New York Times on April 1930:

“Cheap money is a stimulant, also an intoxicant. If the dose is large enough, a substantial temporary effect can be brought about, but headaches follow. If the matter really were that simple, everybody could be an economist, and only the perversity of central banks would keep us from endless prosperity. Merchants and manufacturers will not be induced to increase borrowings, since interest on money borrowed is only one small factor in total costs. But if merchants and manufacturers will not use cheap money, speculators will.”

And that's what's driving the Great Reflation... speculators who are using the cheap interest rates to their advantage.

The money that got pumped into the US economy by the Fed over the past year didn’t get anywhere near “merchants and manufacturers” or small businesses that are now the backbone of the US economy.

Speculators are borrowing at 0% plus or minus short term, and are “playing/gaming” the stock market with much of that money.

One of the bubbles forming again is in oil prices. So perverse is the emerging scenario that you have the US taxpayer advancing money to speculators so they can game the oil market so that US taxpayers must pay more for oil (!).

San Francisco Fed President Janet Yellen made an interesting comment on Tuesday in Hong Kong. She opined about whether monetary policy should be used to lean against "potentially dangerous swings in asset prices. The answer is far from clear, because the use of monetary policy for these ends necessarily compromises the attainment of other macroeconomic goals."

It would appear those 'other macroeconomic goals' involve around creating new bubbles to get themselves and of our current hole - a hole dug by the creation of the 2001 - 2006 bubble.

But how long until it becomes necessary to move to defend the Dollar by dramatically raising interest rates?

We shall see.

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Major mortgage lender risks unpopularity with peers to express his concerns

Last Thursday Peter Aceto, President of ING Direct, told the Toronto Star that he’s worried about Canada’s real estate market.

Aceto made several candid statements and - perhaps even more astonishing - acknowledged that his comments will likely not be popular with money lenders since he is also in the business of selling mortgages.

Do tell?

Aceto said the current low interest rates have caused some Canadians to act "irrationally" in the housing market, potentially taking on too much debt that could lead to economic difficulties down the road.

More significantly Aceto indicated that mortgage lenders share partial responsibility for this situation.

You may recall back in September, Scotiabank economists Derek Holt and Karen Cordes said, in a research note, that "lenders have been scrambling to get enough product to put into the federal government’s Insured Mortgage Purchase Program over the months, and that may have translated into excessively generous financing terms"

Aceto followed up on this theme and said, "we shouldn't be interested in just selling mortgages to get our numbers up for the next quarter."

The concern, as Aceto noted, is that more than 50% of all mortgages in Canada this year were amortizations longer than the standard 25 years.

Buyers take on those long amortizations for only one reason: it allows them to borrow far more than they probably should and leaves them highly vulnerable to catastrophe when interest rates inevitably rise.

Aceto acknowledges this and says he is worried that some consumers are biting off more than they can chew.

As this blog has said all year long, the stage is being set in Canada for a US-style real estate implosion because a great many Canadians have taken on massive mortgages and will be forced to default when the catalyst of rising interest rates kicks in.

Aceto drew on his own California experience to concur with this sentiment.

Aceto's former job at ING was chief risk officer and he spent two years in California during the height of the real estate bubble there. At the time he felt that Canadians would not be as extravagant or recklessly wasteful as their American counterparts.

But when he arrived back in Canada he was surprised to see that some consumers were acting in a similar way.

"Canadians have been proud internally that we're very different than the Americans in the way we behave in terms of our spending habits and the way we deal with credit. But over time we have become a lot closer than we think," said Aceto.

"It's almost as if [consumers] feel very concerned they are missing something with such low rates," said Aceto. "The problem is: can they afford to pay for their mortgage five years from now, when interest rates go back up?"

Bingo!

Aceto joins a growing list of financial community heavyweights who are starting to publically take notice of this issue.

Last week CIBC World Markets senior economist Benjamin Tal told the Toronto Star that consumers are "blinded" by low interest rates. Before that Bank of Canada Governor Mark Carney expressed concern that he may have to 'intervene' in the mortgage market because lenders and borrowers were not being 'prudent'.

Peter Aceto, however, is the first bank president to express concern over the housing market.

Seems the fretting about the future of real estate in Canada with the prospect of rising interest rates is no longer simply a fixation of 'negative bloggers'.

The truly unfortunate thing, though, is that the ultra-low interest rates of 2009 - interest rates slashed as part of a desperate attempt to protect and re-inflate real estate asset prices - will ultimately just intensify the collapse, wreaking far greater havoc on asset prices than if the market had been allowed to correct on its own.

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Sunday Funnies - November 15th, 2009

(click image to enlarge)

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