Some Sunday musings

A few random thoughts first thing this Sunday morning.

Yesterday we noted how the chief economist for RBC Global Asset Management, Eric Lascelles, argued that by the time many current mortgage holders renew their mortgage that the impact of higher interest rates will be mitigated by three years of rising household incomes.

It is fitting that on the day his comments were covered that shocking GDP figures were released showing that Canada's gross domestic product unexpectedly fell by 0.3 percent in May and that the U.S. economy grew at a meager 1.3 percent in the second quarter.

More importantly growth for the first quarter was revised sharply lower.

And just as data from the first quarter in the US was 'revised' lower, analysts are already looking at the second quarter data and figure that it's not accurate either and will be downgraded as well.

• "Just as Q1 2008 was eventually shown as the start of the great recession so will Q2 2011 in subsequent revisions."

So much for three years of rising household incomes.

Speaking of conditions stagnating, former Chinese central bank adviser Yu Yongding repeated his call for China to reduce its Treasury holdings as the American debate about the debt limit drags on. Speaking to reporters at a briefing in Mumbai on Friday Yu said:

• “U.S. bonds are not safe, but people think they are safe. That is a mirage.”

In March, Yu said that China, the biggest foreign holder of Treasuries with $1.16 trillion of the securities, should halt purchases because of the risk of an eventual default. In June, he predicted that credit agencies would limit the severity of any downgrade of the U.S. rating to avoid investor panic.

As China, Russia, Japan et al slow their purchases of US Treasuries, the US Federal Reserve will have no choice but to launch some form of QE3 to monetize the US debt. Increasingly the US economy (and by extension: Canada's economy) look to be entering the same decade plus malaise that Japan is dealing with.

There was an excellent analogy offered in the comments section over at Vancouver Condo Info yesterday about the actions our governement took during the first phase of the financial crisis (2008-2011):

• "The low emergency rates were supposed to be used as a spare tire, while the regular tire was to get fixed. But they couldn’t afford the repair, and could not buy a new tire as the credit card was maxed, so they ran the spare tire so long the tread is worn and can’t get any traction."

The economy has stalled and conditions are not improving. As the real estate market turns, the impact on Lower Mainland homeowners with high mortgages is going to be severe.

Our friends over on VREAA documented a poignant comment yesterday which represents the situation shared by many who have bought in the last five years in the Lower Mainland.  Calling into the Bill Good radio show, a caller said:

• “I work long hours to be able to pay for a house. I drive long distances to get to and from work. I barely do anything in my expensive house other than sleep and go back to work each day. And on top of that [speaking about the upcoming additional gas tax] every time I turn around I’m being taxed for something else.”

Bill Good replied that he thought the caller was "speaking for thousands of people right now.”

Indeed he is.

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"They wouldn't dare"

After the financial crisis of 2008, as the greatest recession since the Great Depression of the 1930s set in, Canada's economy fared remarkably well.

So well, in fact, that many Canadians are oblivious to all this talk of a 'Great Recession' around the world.

Everyone is aware of the 2008 Financial Crisis... but few appreciate how severe the underlying credit crunch was.

And that's because Canadians never really felt that crunch.  The banking sector in Canada insulated our citizens from the worst of that crunch.  Because of the emergency level interest rates brought in by the Federal Government... because the Canadian Mortgage and Housing Corporation (CMHC) dramatically lowered the requirements to qualify for a fully backstopped mortgage... and because CMHC insurance fully guaranteed mortgages given out by Canadian banks, those Canadian banks  kept on lending money to Canadians.

As a result Canadians kept on buying. 

But the availability of cheap credit has driven Canadian household debt levels to record highs. Household debt as measured against disposable income currently sits at a record high of 147%.

As Canadians have piled into massive consumer spending, and buying as much house as they could afford under emergency level historic low interest rates, there is this perception that the Bank of Canada will never raise interest rates because they wouldn't dare upset the economy.

This, of course, if pure nonsense.

Echoing this sentiment is the chief economist for  RBC Global Asset Management, Eric Lascelles.

• “There is a popular misconception that the Bank of Canada cannot afford to raise interest rates because this would prove too damaging for mortgage holders. The opposite is in fact true. The reality is that the Bank of Canada cannot afford to delay raising interest rates, for precisely the same reason. The longer the bank delays, the more marginal borrowers will enter the market and be walloped when rates rise, and the further home prices will go above their equilibrium levels, only to tumble later.”

You can clearly see how the domino's will inevitably fall here.

Once the Bank of Canada raises its key lending rate from the current “astonishingly cheap” one per cent, costs of servicing mortgage and other debts will rise. 

These increased costs will sap consumer spending, housing prices will fall as lower-tier buyers are forced out of the market by diminished affordability, and the endless annual increases in real estate values will cease.

Just as so many Australian's (as we saw in yesterday's Aussie TV clip) were dependant on rising real estate, so are many Canadians. And as lower-tier buyers are forced out of the market by diminished affordability, the vicious catch-22 cycle will begin.  The lack of buyers will increase inventory.  Increased inventory will create competition for what buyers remain.  And a 'high supply, limited buyers' condition will start collapsing the market.

The Reserve Bank of Australia first started raising their interest rates back in October 2009.

By January 2010 it was evident the Australian collapse has started.  As Mish Shedlock observed:

• "The day of reckoning has finally arrived for Australia. A day of reckoning awaits Canada, China, and the UK as well. It's too late now to do much of anything except: exit the Australian stock market, get out of the Australian dollar, pick up some popcorn and stay on the sidelines and watch the collapse unfold."

Since January 2010 the Australian collapse has picked up speed. Yesterday's Australian TV clip quoted a stunned Aussie who said "I don't think anyone saw it coming."

That will be our future.  So many do not see what is coming. And right now we're still telling ourselves, "they wouldn't dare raise interest rates."

But as the chief economist for RBC Global Asset Management noted... they most certainly will.

The risk is clearly greatest of all for those who have just purchased a home since the 2008 financial crisis.

All the people who were lured by emergency level interest rates over the last 3 years are, on average, earlier in their career, and their income has not yet fully blossomed. They often begin with little equity in their dwelling, having neither contributed much equity up front, nor made many mortgage payments, nor have they enjoyed the fruit of rising home prices.

Their debt load is likely at its lifetime peak.

As Lascelles’ notes, the outcome of rising rates will be quite painful these buyers.

The only remaining question is... do these buyers represent a systemic risk similar to the devastation on the U.S. economy of its housing collapse?

Interestingly Lascelles discounts this outcome.  Despite that fact that many will face higher rates when they renew, Lascelles argues that by the time many do renew the impact will be mitigated by three years of rising household incomes.

A downturn saved by a rebounding economy? Didn't American economists predict that same outcome in the United States?

In 2007 many well known economists in America (like the infamous Ben Stein in the clip below) were adamant that the few who would be affected by resetting mortgages at higher interest rates would not adversely affect the overall real estate market. 

And in the summer of 2011, a similar sentiment seems to exist in Canada.

Not only will interest rates will rise, but the mantra of "they wouldn't dare" will give way to "I don't think anyone saw it coming"... just like it now has in Australia.

And just like we see in Australia today, the impact here will be more severe than expected.

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Email: village_whisperer@live.ca
Click 'comments' below to contribute to this post.

Please read disclaimer at bottom of blog.