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June 21, 2021 | The Tightening

A best-selling Canadian author of 14 books on economic trends, real estate, the financial crisis, personal finance strategies, taxation and politics. Nationally-known speaker and lecturer on macroeconomics, the housing market and investment techniques. He is a licensed Investment Advisor with a fee-based, no-commission Toronto-based practice serving clients across Canada.

Justin Trudeau does not set interest rates. Nor does Chrystia Freeland, the finance ministress. In fact, monetary policy has been divorced from politics since March of 1935 when the Bank of Canada was formed as a standalone agency out of the ashes of the Great Depression, and out of the hands of politicians.

It’s the central bank’s job to keep inflation under control, stabilize the currency and support the economy. The BoC isn’t part of the government. It doesn’t take instructions from the former Langevin Block, where the PM hangs out. One thing politicians learned ninety years ago was just how awesomely they could screw things up in times of a true economic crisis. The 1930s were made far, far worse with policies like easy money followed by harsh protectionism.

The CB drops rates when the economy slumps in order to encourage borrowing, spending, less saving and more activity. It hikes the cost of money when the economy is on fire with prices and inflation romping to cool spending and encourage thrift. Gas and brake. Brake and gas.

As you know, rates crashed in 2008-9 during the credit crisis and had hardly restored to normal levels before the pandemic hit. So for the past dozen years loans and mortgages have been so low people have gorged on them, borrowed up a storm and inflated asset values. Now 90% of us can no longer afford real estate.

Some people (including all the unfortunates who come to this pathetic blog) think it’s impossible for rates to ever rise since families are so indebted ($1.69 trillion in outstanding mortgages). They also believe ‘the government’ will not allow hikes to swell for the same reason.

Here are two facts worth remembering. First, central bankers desperately want and need to up rates. If not, when the next economic mess happens they’ll be out of ammunition to fight it. You can’t drop rates much when they’re already in the ditch. Any recession (or worse) could be seriously elongated.

Second, our CB may be independent from politicians but it sure isn’t divorced from the US Fed. Over the past decades our bank has moved 93% of the time in sync with the Americans. If that didn’t happen, our dollar would be jerked around and the immense cross-border trade whacked.

Will the Fed tighten? Yes, of course. Officially there will be two increases by the end of 2023, but the bond market believes it will be more like eight. In Canada our tightening cycle is expected to begin next year with rates climbing above the previous peak for the first time in many, many years – thanks to a post-Covid economic blow-out.

This comes in no small part because the feds are spending unprecedented amounts, maxing out the maple credit card, running up an historic deficit and pushing the national debt into the red zone. All that money means inflation. It’s the stuff CBers nightmare over.

The market (bonds and swaps) expects the current B0C rate of 0.25% to be 2% within sixty months. That’s seven increases – still well below the average number of increases in a Fed tightening cycle. Previously we told you that major lenders in Canada are anticipating eight.

The ‘first casualty’: housing

“The housing market will probably be the first casualty of higher rates,” says economist Charles St-Arnaud in a new report (he worked at the Bank of Canada and Morgan Stanley). “When rates go up, that affordability will disappear very, very quickly.”

The 2% mark for the bank may be low, since the BoC has said that a ‘neutral’ rate could be as high as 2.75%. Of course eight or ten increases in the benchmark rate would boost the commercial bank prime from 2.45% to at least 4% and could double the cost for five-year mortgages.

Why would this occur when households have taken on historic levels of debt and the real estate market now accounts for a big piece (about 15%) of the GDP?

Simple. If the CB is to maintain its mandate of keeping inflation in check and prevent currency erosion there’s no choice. Government pandemic largesse and excessive deficit spending put more than $100 billion into Canadian bank accounts while Covid lockdowns crashed spending, pushing the savings rate to a multi-decades high. This is about to be unleashed. Already the economy is gushing with a 6% growth rate. Puppies and plywood are premium-priced. Bank profits are massive. We’re only starting the reopening process. When the US border opens, when travel and tourism take off, when 75% of us are fully vaxxed then (a) there’s no need for low rates to add stimulus and (b) the tightening must begin to corral price and asset inflation.

Recall the inverse relationship between real estate and rates? It’s real. Economist St-Arnaud figures if the cost of money rises 2.5% that housing markets in the GTA, Vancouver, Montréal and Ottawa would be at risk of a bust. But he also found if current prices rise another 10% and interest rates increase only 1.5% the result will be the same. Down she goes.

Remember a fifth of all new real estate buyers in the GTA and Van have debt-to-income ratios of 450% or greater. Meanwhile new mortgage borrowing’s been running at $17 billion a month. All this has pushed the national house price up 32% in a year. The savings rate during the pandemic surged to 14%. Incomes barely moved. There are home loans available at less than 1%. None of this is normal. Nor will it last.

So, no, Justin will not save you. Nice socks, though.

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June 21st, 2021

Posted In: The Greater Fool

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