"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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Speaking of 'Tulip Mania'

It's 2011 and there is definitely an emerging 'theme' to real estate for the early part of this year.

As you know, for the past six months there has been a dramatic decline in the number of real estate sales. Yet the average price of houses seems to be rising - huh?

Realtor Larry Yatkowsky commented on this right off the bat as the New Year started.

• "Vancouver real estate’s New Year is starting off with a bang. For the first time in many months, the aggregate number of properties for sale in the lower mainland has tumbled below the 17,000 mark. Vancouver Realtors® began whispering in the early part of December that it was becoming more difficult to find quality homes for their buyers."

Declining inventory leads to bidding wars as buyers fight over a shrinking pool of available inventory.

Interestingly a similar situation has been developing in Australia.

Australia has also gone through a stretch where listings have been declining. Predictions by realtors Down Under have called for R/E prices to remain stable or grow by 5-6% in 2011 due to an underlying shortage of properties.

But new figures suggest that the Aussie shortage has been overblown and that the figures "dispel the myth of property undersupply in most cities, and says certain capitals such as Brisbane are actually recording a dangerously high level of properties on the market."

And just who do you think propagated that 'myth'?

During the 2008/2009 slowdown, the local real estate industry urged sellers to pull listings off the market. This was a strategy, done on purpose in order to create 'demand' and stave off further declines.

The same strategy was urged by the Industry during the Fall months as the media was besieged with month after month of negative press regarding declining sales.

In Australia, the Reserve Bank is contemplating another rate increase and it is suggested that such a move could accelerate a downturn just as the pent up supply from a contrived 'shortage' hits the Spring market.

Is the lack of supply a R/E fueled lie? Is the truth more a case of the fact that there is no lack of supply, just speculators sitting on a lot of inventory that can/will be put on the market in short order?

American blogger Mike "Mish" Shedlock thinks so and examines the Australian developments in this eerily familiar sounding post title: Australia's "Tulip Mania" About To Crash, As Housing Shortage Proves A Massive Myth.

I say 'eerily familiar' because it was just yesterday I was comparing the situation in the Vancouver suburb of Richmond in the same 'Tulip Mania' fashion.

Mish concludes that:

• "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
  * Stay on the sidelines and watch the collapse unfold"

I'd personally recommend getting the Costco size case of 'Jiffy Pop' myself.

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Blissfully blind...

"It's all about interest rates."

The phrase has become almost a mini-mantra on this blog. I find myself repeating it almost on a daily basis when asked for my opinion from colleagues on interest rates.

And if you read this blog regularly, you know my thoughts on where they are going. The spectre of sovereign debt will almost assuredly push rates back to levels seen in the mid 1970s.

It's not an opinion many share.

Casual conversations reveal that most simply can't fathom rates rising all that much. People can see the Bank of Canada raising rates 1 or 2 percent... but no more than that.

The vast majority are adamant about that, despite knowing full well that our current 0.25% Bank of Canada benchmark lending rate is an emergency level.

It seems, however, that people are coming to treat that rate as 'normal'.

Oh we live in such an insular world, don't we?

Perhaps that's why double takes abounded today when I casually mentioned that the central bank of Austrialia raised it's interest rate for the fifth time since October.

More importantly the Reserve Bank of Australia's governor, Glen Stevens, sees interest rates returning to "average" levels and warns about rising inflation.

Now... on a day when the world sees Canada surging economy to be strong enough to push the Canadian dollar to par with that of the United States, does anyone pause to wonder what 'average' interest rate levels are here in Canada?

Over the past 20 years that would be... umm... 8.25%.

Inflation pushed those rates into the mid teens and up to 22%.

But why worry about things like that? It's not as if Canadians will be responsible for hundreds of thousands of dollars of debt for excessively long periods of time, right?

I mean, how much can things change in 35 years?

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Hike Rates Often and Fast

You may recall that back on February 10th, we noted that the heads of the country's six largest banks had privately told federal government policy makers that they fear the wide-ranging economic fallout of a U.S. style binge-and-collapse in housing hitting Canada.

These pressures lead to the change in Canadian mortgage rules that were announced on February 16th.

It may interest you to know that those aren't the only pressures being exerted for change.

The C.D. Howe Institute put out this paper last week urging the Bank of Canada to raise rates aggressively once its rate hike moratorium ends on June 30.

The report stated:

• The Bank (of Canada) should keep its conditional commitment, but should thereafter raise the overnight rate sharply by 50 basis points at every announcement date (after June 2010) until mid-2011.
• If inflation continues to rise, the BoC should be prepared to hike rates proportionately more. This assertive policy style is based on the 'Taylor Principle' - after U.S. economist, John B. Taylor.
• Heading off inflation will necessitate “aggressive” rate increases (50 basis points per BoC meeting), starting this summer.

This report comes on the heels of the latest rate hike by the Reserve Bank of Australia which raised it's central rate by a quarter percent to 4%.

Canada's rate, by contrast, remains at 0.25%.

If the advice were implimented, you would have a five year rate rising to near the historical 20 year average of 8.25%.

You can almost hear the ticking sound now, can't you?

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Gathering Stormclouds

It comes as no surprise to readers of this blog to know that I firmly believe that higher interest rates loom in the not too distant future.

And when that circumstance comes to pass, Canadians are gonna get crushed financially.

Just look at how much debt Canadian households are carrying relative to their personal disposable income.

We like to say we are different from Americans, but it's hard to buy into that malarkey when you study the Bank of Canada (BOC) data. According to the BOC, the debt-to-income ratio of households in this country stood at 142% in the second quarter of 2009. That means for every dollar Canadians earned, Canadians owed $1.42 in debt.

In 2005 that figure stood at 116%.

Not only is that debt level exploding, but the BOC estimates that the ratio will rise to 160% in two years!

That's basically where it is for American households. And when it comes to household debt relative to GDP, Canadians and Americans are already neck and neck.

Shockingly, Canada is virtually the only country where households have taken on more debt during this recession. While total household debt in foreclosure-ravaged America shrank 1.7% over the last year, debt levels here jumped 7%. According to Statistics Canada, in November personal lines of credit surged 20% from the year before, loans for home renovations were up 31%, and balances of credit cards jumped another 6.9%.

But by far the most interesting statistic is that, in dollar terms, most of the increase in household debt has come as the result of the huge mortgages people are taking out to buy homes at today’s soaring prices. Over the past two difficult years of the economy, the total residential mortgage debt load in Canada ballooned 18.

“We’re the anomaly in global markets,” says Derek Holt, an economist at Scotia Capital. “We continue to climb to new highs with house prices and we haven’t seen any deleveraging among households. What’s so special about Canada that we should be experiencing this while every other industrialized economy went down and stayed down?”

Now we've talked at length here about how the BOC has been pounding warning drums to warn Canadians not to get used to the abnormally low interest rates of the last year.

And the 800lb gorilla in the room is those skyrocketing debt levels.

When interest rates begin to rise from their record lows (have I mentioned how this is, IMHO, a certainty?), borrowing costs will rise and hundreds of thousands of Canadian families will face a brutal cash crunch.

How bad is it going to be?

Recall that the BOC conducted a series of theoretical stress tests to see how Canadian households will fare should interest rates rise.

I wasn't aware of the values applied, but I am now advised that the stress tests analyzed what would happen if rates rose between 3.2% and 4.5% by mid-2012.

With the BOC benchmark rate currently at just 0.25 per cent, that is a sizable jump. And when a household’s debt-to-service ratio, a measure of monthly payments relative to income, breaks past the 40% mark, it’s considered to be “financially vulnerable” to financial shock.

What the bank found in its review was that if rates rose to the higher level, 9.6% of households would find themselves in that danger zone.

Amazingly, the BOC's test scenario of a jump in rates to even as high as 4.5% would still leave mortgage rates low by historical standards. Especially if, as many fear, the trillions of dollars in emergency liquidity that’s been pumped into the economy sparks inflation. But according to Ian Lee, a former mortgage banker turned Carleton University professor, given today’s insanely low levels, rates don’t need to jump that much to wreak havoc on Canada’s debtor class. “I was in the industry when mortgage rates went through the roof and I was throwing middle class owners out of their homes,” he says. “We’ve seen this movie before."

Yes we have... and it wasn't pretty.

In fact we only have to look across the Pacific Ocean for a preview of how our future will be playing out.

In this Bloomberg story we get a glimpse of what is happening in Australia. The Aussies, like Canada, took emergency measures to stave off a collapse in their real estate industry.

And just like in Canada, the result was rampant price speculation in real estate.

But when the incentives to buy ended and now that interest rates have risen (the Australian central bank rate is now 3.25%), the Australian real estate market is starting to get hit.

As the Bloomberg story notes, rising rates are starting to trigger default conditions on Australian mortgages.

Last week a survey found 45% of all buyers who purchased in the last 18 months are under severe mortgage stress, with many forced to use credit cards to keep up their home loans.

And - what a surprise - when we take a closer look we find that Australians have a debt-to-disposable income ratio of 156% - almost identical to Canada's (145%).

The scary thing is that the 3.25% Australian central bank rate is nowhere near to topping out.

Australia is just starting to feel the pain.

Meanwhile ours looms ominously on the horizon.

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Pass the Salt!

Yesterday shortly after I commented that, in the CHMC world, there is never an outlook that isn't sunshine, lollipops and rainbows - the Financial Post echoed the sentiment: CMHC forecasts are best taken with a large grain of salt.

• "What do we find so beguiling? Must be the gentle mix of fact and whimsy. No matter what the situation, a CMHC forecast is always soothing, always positive, always upbeat about real estate."

Speaking of beguiling, did you get a chance to check out this link posted by a faithful reader in the comments section yesterday?

We are treated to 'the good news' about cheap money from a couple of mortgage brokers. Even better, this website has been cited as "first and foremost an up-to-date source of unbiased mortgage advice and industry trends."

The good news offered is in response to media stories about the Bank of Canada's warnings about interest rates. Thus, "13 reasons why low rates and current lending guidelines might not be a disaster in the making."

In one, the Company insists that anyone who receives a 5% down/35 year amortization mortgage "are getting them because they’re well qualified. It’s that simple." (Presumably Mark Carney can cancel his upcoming study).

Then they promptly follow that up with an assertion that some of those 'qualified' borrows aren't actually qualified (huh?). They tell us, "as a side note: The frequency of lender “exceptions” (lenders overlooking guidelines) are nowhere near where they were pre-August 2007."

Didn't they just say anyone who receives the 5/35 mortgage is qualified, "it's that simple"?

The other 13 'points' reference dubious data, but the one that stands out most is the last in which we "suppose a doomsday scenario unfolds and rates rise 4% (to say, 8% on a 5-year fixed). If the average household income is $61,800 today, and the mortgage is $250,000, that would necessitate a $10,400 pre-tax income jump in five years to pay the extra debt service. That’s just over 3% annual wage growth—not an unreasonable earnings growth assumption."

No worries, right?

Well, not exactly.

First off, are we to understand that doomsday for these guys is interest rates rising to 8%?

You're joking. Even the Bank of Canada is telling Canadians to expect interest rates to go back to normal... and normal for the last 20 years is 8.25%

And who among those who bought a single family home in the Lower Mainland in the past three years (where where the average detached home is selling for $914,000) has a mortgage of only $250,000?

The whole article gives new meaning to the phrase 'skewed analysis viewed through rose-coloured glasses'.

And since we're on the topic of reality checks, Australia announced yesterday that they are raising interest rates for the second consecutive month with the central bank raising their key rate 17% in the last 60 days.

Higher rates are coming. Bank of Canada Governor Carney knows it, which is why he has been sounding alarm bells the last few months.

And one only has to look at US Government debt to see the scope of the pressures that loom on the horizon.

America must roll over $3.4 trillion in debt over the next four years. This $3.4 trillion does not include any additional borrowing that may be required for other government programs (wars, healthcare, wars, school lunches). Unless the US rediscovers fiscal prudence, annual deficits of $1.4 trillion mean the United States faces the prospect of having to find $9 trillion to fund it's budgets.

There are only so many savings available to borrow, after all. And the competition for capital is going to force rates up to late 1970s levels.

And what will happen if America can't find anyone willing to finance its deficits?

One of the luxuries of issuing debts in the currency you happen to also print currency is that you can print money to pay for them. Technically the Fed can create new money to buy debt issued by the Treasury, funding deficits ad infinitum.

Which is why so many people are fretting about the United States monetizing the debt and why gold hit $1,084 an ounce yesterday (at the time this was written, gold had hit $1,092 on the kitco 24 hour chart).

You have to laugh at the idea that 8% interest rates are a doomsday scenario.

In 1975, an 8% five year mortgage rate would have been considered ridiculously cheap and it's not hard to see how that will be the case again before too long.

Seems to me we need more than a simple grain of salt to take with these 'don't worry, be happy' rationalizations.

Pass the shaker and pour it on, baby.

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Hedge-Fund Bets On Hyperinflation... and has inflation 'officially' started?

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UPDATE: Barclay's targets Gold at $1,500
UPDATE: Gold continues climb with record closing high of $1,044.20. During day went as high as $1,049.70 (note: record high intra-day mark was $1,060 set in March 2008).

The hedge fund Hayman Advisors (HA) is drawing attention again.

HA is most famous for betting against subprime mortgages in 2007. When the US housing bubble popped, they made billions of dollars with their hedge. As a result, HA's economic views now received a heightened level of attention.

And the blogosphere is a tither about their latest, controversial letter to clients predicting that the U.S. may experience hyper-inflation.

Now the fact that many people think that inflation will follow the massive fiscal and monetary government stimulus that has been injected to fight the the recession and financial crisis is nothing new.

We've posted about it quite a bit.

But hyper-inflation?... that is the extreme.

Hyper-inflation would mean inflation in the ballpark of 30% per year -- at least. Generally hyper-inflation is measured by the month or day, not year, because the numbers are so high.

What has caught everyone's attention with HA's latest advice is their reference to a study by Peter Bernholz.

There have been twenty eight episodes of hyper-inflation of national economies in the twentieth century with 20 occurring after 1980. In his most recent book, Monetary regimes and Inflation; History, Economic, & Political Relationships, Bernholz analyzes the 12 largest episodes of hyper-inflation - all of which were caused by financing huge public budget deficits through money creation.

"In the 12 largest episodes of hyper-inflation the tipping point for hyper-inflation occurs when the government’s deficit exceeds 40% of its expenditures."

The study notes that according to the current Office of Management and Budget projections… the U.S. will run deficits equal to 43.3% and 39.9% of expenditures in 2009 and 2010, respectively. In other words roughly 40% of what the US government is spending has to be borrowed.

It prompts HA to ask it's clients, "has the U.S. reached the critical tipping point?"

The hedge fund's letter is attracting significant interest for several reasons. First of all because it's a hyper-inflation argument that doesn't seem wacky - it's rooted in historical observation.

Secondly it has nothing to do with the massive monetary stimulus by the Federal Reserve, which could cause additional inflationary pressures. So even if you believe that the Fed can control their side of the equation, the government spending might still cause inflation to get out of hand.

Skeptics counter that the U.S. has a more robust, developed and sophisticated economy than most places where hyper-inflation has occurred. They say that fiscal and monetary policy would be seriously altered to avoid incredible levels of inflation if the U.S. found itself facing such a predicament.

None-the-less, successfully keeping inflation as low as it has been in recent years seems highly unlikely with each passing day. And whether you buy into the fund's logic or not, its letter is an interesting one. It also provides analysis on China and Japan.

If you have some time to kill and interest, you might want to give it a read.

On another inflation note, the Reserve Bank of Australia became the first G-20 nation to raise interest rates yesterday. The RBA bumped interest rates up 25 basis points to 3.25%, a move observers were convinced wouldn’t come until at least November. Thus, Australia is implicitly declaring the end of its economic downturn.

The move is raising alarm bells because the first hike is seen as opening a Pandora's box of interest rate hikes around the world.

Chuck Butler of EverBank says that, “if the RBA went this soon, then we can expect Norway's Norges Bank to push its rate hike earlier on the calendar, maybe even later this month! And it won't be the only one! Look for New Zealand to hike rates this year, and who knows what other country will follow after that.”

And you will recall that Bank of Canada governor Mark Carney tempered his promise to keep our nation's rate at 0.25% only if inflationary pressures didn't start to emerge.

Well... they are now officially emerging.

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