"Get ready for steep rate hikes in 2011", says economist

(Click on image above to enlarge)

Two topics for the price of one today. Some interesting comments out of China that don't bode well for interest rates. More on that later in the post, but first...

Yesterday it was Alan Greenspan, today it's Laurentian Bank Securities.

In an article in the Financial Post, the chief economist of Laurentian Bank Securities (Carlos Leitao) warns that when the Bank of Canada does start raising its key policy interest rate in either late 2010 or early 2011, Canadians should brace for "aggressive" increases.

"The Bank of Canada is likely to begin hiking rates after unemployment peaks (in early 2010) and before inflation hits the preferred 2% target (sometime in mid-2011). Once that period comes, Canadians should prepare for steep rate hikes. An aggressive tightening – rather than a gradual one - will be necessary because rates are extremely low. A ‘measured pace' would not be appropriate to ‘normalize' rates when the starting point is virtually zero."

Analysts say one of the key causes of the financial crisis was that the U.S. Federal Reserve kept its key policy rate too low for too long. When it did begin raising rates in 2004, they say, the Fed opted by gradual increases of 25 basis points – not nearly aggressive enough, in retrospect, to cool down the white-hot housing bubble that resulted in the financial market meltdown almost a year ago.

An aggressive raising of interest rates means we are likely to see a mix of 50, 75 and even 100 basis points hikes in successive months - when the time comes.

Leitao says that the Bank of Canada's key policy rate will be at just over 3% by the end of 2011.

3% as a key policy rate.

Think about that for a moment.

It may not sound like much, but remember, the current Bank of Canada rate is 0.25%. If the Bank of Canada raises that rate by just 1%, what would that do to a variable rate mortgage (VRM) of 2.25%?

A 1% raise represents a 45% increase to the VRM.

A 45% increase in your monthly mortgage payments - overnight.

A month later... another 45% increase from that original VRM rate. Suddenly your paying 90% more and the Bank of Canada hasn't even hit that 3% key rate target.

Will borrowers using VRM's save themselves by locking into a 5 year fixed mortgage?

It would only take a couple of aggressive bank moves to put five-year mortgage rates back into the 8% range – the average of the last twenty years. And as we discussed earlier this week, a raise of only 2% on the five-year mortgage rate would put a large number of current homeowners in serious trouble.

But if they can lock in at today's best five year mortgage rate of 3.79%... it's only a temporary salvation.

That's because rates will not be coming back down for decades. Those on ultra-low VRM's who lock into five year rates to 'fix' their situation are only delaying their day of reckoning. When they renew at 8% (or higher) five years from now, they are hooped.

At reset time going from 3.79% to 8% would be huge.

As stated two days ago, the Lower Mainland will almost certainly be hit with a tsunami of defaults and foreclosures as these mortgages reset at higher rates. Having already purchased the maximum they could afford at these historic low rates, who amongst those who purchased like that under these conditions will be able to afford a jump of $1,700 (or more) in their monthly payments?

That Dilbert cartoon strip at the top of this post will prove to be very prophetic.

China

Adding another dimension to future concerns about interest rates are the latest developments from China.

Last weekend at the Ambrosetti Workshop, a financial workshop gathering of politicians and global strategists at Lake Como in Italy, Cheng Siwei made an interesting speech.

Mr. Cheng was, until recently, Vice-Chairman of the Communist Party’s Standing Committee. Now he is a sort of economic ambassador for China around the world.

What he said about US monetary policy would appear to validate the long-held belief that China has fundamentally lost confidence in the US dollar and is going to shift to a partial gold standard through reserve accumulation.

In his speech Cheng played down other metals such as copper, saying that they could not double as a proxy currency or store of wealth.

“Gold is definitely an alternative, but when we buy, the price goes up. We have to do it carefully so as not stimulate the market,” he said.

In other words, China is buying the dips, and will continue to do so as a systematic policy.

Mr Cheng's comments capture exactly what observation of gold price action suggests is happening.

Every time it looks as if the bullion market is going to buckle, some big force steps in from the unknown.

Investors long-suspected that it was China. Earlier this year it was discovered that Beijing had, in fact, doubled their nation's gold reserves to 1054 tonnes. Fait accompli first. Announcement long after.

Standing back, you can see that the steady rise in gold over the last eight years to $1000 an ounce this week – outperforming US equities fourfold, even with reinvested dividends – has roughly tracked the emergence of China as a superpower in foreign reserve holdings (now $2 trillion).

Mr Cheng (and Beijing) also takes a dim view of America's monetary experiments at the Federal Reserve.

“If they keep printing money to buy bonds it will lead to inflation, and after a year or two the dollar will fall hard. Most of our foreign reserves are in US bonds and this is very difficult to change, so we will diversify incremental reserves into euros, yen, and other currencies,” he said.

And that's the line that should put you on high alert when it comes to our real estate mortgage interest rates.

It means China will positively reduce its purchases of US treasuries in the coming years.

As they decrease those purchases, yeilds (interest rates) will rise to make them attractive to other potential buyers.

Mr. Cheng also made a VERY interesting comment about the economy in China, echoing what we said here several weeks ago:

“Credit in China is too loose. We have a bubble in the housing market and in stocks so we have to be very careful, because this could fall down.”

Of course, China could end this problem by letting the yuan rise to its proper value, but China is trapped.

Wafer-thin profit margins on exports mean that vast chunks of Chinese industry would go bust if the yuan rose enough to close the trade surplus. China’s exports were down 23% in July from a year before even at the current exchange rate, and exports make up 40% of GDP. “We have lost 20 million jobs in this crisis,” Cheng said (!).

China’s mercantilist export strategy has led the country into a cul-de-sac.

China must continue to run its trade surplus. And because of the surplus it must accumulate hundreds of billions more in reserves.

But rather than continue to support the United States' ever-expanding debt by buying treasuries with those surpluses, it plans on diversifying into IMF Special Drawing Rights and gold.

The writing is on the wall for interest rates.

"La, la, la, la, la...."

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