OCTOBER 17, 2011
CREA released their latest resale figures and the Bank of Canada released some rather downbeat business outlook data. Unfortunately, that will have to wait until tomorrow. There’s only so much brain juice to go around. Today, I’ve used my daily ration looking at soft landings in real estate.
Can the Bank of Canada orchestrate a 'soft landing'?
I've had several people email me the following article asking if the Bank of Canada is going to try to raise inflation as a means of causing a soft landing in the housing market:
Some key quotes:
"The new five-year mandate is likely to include a forceful assertion of what he calls “flexible inflation targeting,” or his right to respond to economic shocks or dangerous buildups of credit by taking longer than usual to bring inflation to the central bank’s 2-per-cent target."
"Mr. Carney has kept his benchmark interest rate on hold in the face of hotter-than-expected inflation, judging that securing the recovery is more important than being precisely on target."
I don’t think this is earth-shattering news. Carney doesn’t want to have to raise rates during an anaemic recovery just because inflation pressures hit 3% when it means crushing the economy in the process. I don’t think that’s shocking.
I have no doubt that Carney and company would love for inflation to buoy income growth and consumption. It’s also very clear that Carney is concerned with house prices at their current levels. That was made that abundantly clear in a recent speech in Vancouver and confirmed in the Bank’s latest financial review.
They get the problem, as does any person willing to look at the rate of growth in house prices relative to all fundamentals. Sure we can at least debate what the next decade will hold for housing, but unless a person is entirely disconnected from reality, it should not escape us that house prices (and debt levels) cannot outpace incomes, GDP, inflation, and rents by 2-3 times into the indefinite future. It’s the height of folly to believe they can.
That leaves really only a handful of options going forward:
- 1) In theory, the housing market could continue to rise, though modestly, while underlying fundamentals catch up. The problem is that once we strip out housing-related industries, we find that the rest of the economy has experienced near-zero real GDP growth since 2006. This argues very strongly that economic growth, and hence income growth, will be hard to come by apart from continued strong gains in housing.
- 2) Another option is that house prices fall, eventually realigning with fundamentals. I know it’s a shocking thought, but it happens more regularly than people realize...just not in the past 20 years. To assume that this represents a stable norm and house prices never fall in Canada is to give in to that wonderful psychological tendency known as recency bias.
- 3) The other possible option is that housing flat lines while fundamentals catch up. This is the popular “soft landing” thesis. It’s not impossible, but it is highly unlikely. And although it is every central banker’s wet dream to gently inflate their way out of a consumer credit bubble, it will be exceptionally difficult to orchestrate a soft landing in the credit-driven housing market in this manner.
Why a soft landing in general is unlikely:
The reality is that sharp deviations from fundamentals seldom correct by moving sideways. In real terms, prices have risen higher and for a longer length of time than at any point in time over the past 40 years (as far back as there is data on house prices). Relative to underlying fundamentals, things have never looked so ugly (unless, of course, we look at ‘affordability’, which, as I showed yesterday, is a nearly useless metric).
Don’t take my word for it. What does the research say on the likelihood of a soft landing?
Let’s start with a fascinating 2006 article from the Evolutionary and Institutional Economics Review journal, titled, “Real estate price peaks- A comparative overview.” Among their key findings:
"First, we emphasize that the real estate price peaks which are currently under way in many industrialized countrie...share many of the characteristics of previous historical price peaks.
In particular, we show that: (i) In the present episode real price increases are, at least for now, of the same order of magnitude as in previous episodes, typically of the order of 80% to 100%. (ii) Historically, price peaks turned out to be symmetrical with respect to the peak; soft landing, i.e., an upgoing phase followed by a plateau, has rarely (if ever) been observed."
Rarely if ever observed, eh?
Let’s not stop there. Consider an article titled, “Crashes in Real Estate Prices: Causes and Predictability,” published in the journal Urban Studies in July 2010. It had the following to say:
"A systematic deviation of a price from its fundamental value over a sustained period of time, on the other hand, can only be the result of speculation. Such deviation is thus called a speculative bubble."
"History tells us that the faster and larger the bubble inflates, the more likely it will burst in the less benign way."
This is an observation made not only by academics who study the real estate markets, but also by some of the best Wall Street money managers and analysts who recognize that all asset markets go through booms and subsequent pull-backs. Consider the first four of legendary investor Bob Farrell’s ten rules of investing, which can be applied quite nicely to real estate:
- 1) Markets tend to return to the mean over time
- 2) Excesses in one direction will lead to an opposite excess in the other direction
- 3) There are no new eras -- excesses are never permanent
- 4) Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways
Why a soft landing via rising inflation is nearly impossible:
Here’s where things get interesting. Those with some understanding of finance and economics understand that there are essentially two significant interest rates that are important for the housing market: One is set by the Bank of Canada and typically dictates the interest rate you pay on revolving credit or variable rate mortgages. The other is determined in the bond market and dictates the price you would pay for a fixed mortgage.
To repeat: One is set by the Bank of Canada while the other is set in the bond market. While the bond market can force the Bank of Canada to ‘defend’ its rate in the event of rising bond market rates, the BoC can do so only at great risk. The reality is that when it comes to interest rates, the power is ultimately in the hands of the bond market.
While some have suggested that the Bank of Canada can hold interest rates low, allowing more credit to flow into the market and keeping payments on variable mortgages low to keep prices buoyant, things are never so simple.
In 2010, mortgage financing rules were changed so that people hoping to take advantage of ultra low variable mortgage interest rates (based on the overnight rate at the Bank of Canada) would have to still qualify for a mortgage amount using what is called the Mortgage Qualifying Rate (MQR). This rate is based on the yield of the 5 year bond.
Said very simply, even if someone wants to take advantage of a ridiculously low 2.2% variable rate mortgage, the amount they qualify for is based on the mortgage qualifying rate, which is currently 5.29%. So where someone’s salary might afford them a larger approved mortgage if the lending bank used the 2.2% in their calculations, they are forced to calculate their mortgage using the 5.29% instead, meaning that their total mortgage would actually be smaller. It hasn’t been an issue yet for the real estate market since the 5 year bond yield (upon which the mortgage qualifying rate is based) has fallen from 3% in April 2010, when the changes were made, to 1.6% today:
But let’s connect the dots to see why this is problematic to the ‘soft landing’ crowd: Interest rates in the bond market reflect a risk premium (to compensate for the fact that a borrower could default) and an inflation expectation (to compensate for lost purchasing power if the money is repaid in borrowed dollars).
It’s this second point that is most important. The bottom line is that if inflation were to begin rising, and traders believed it would remain high, the interest rate on the 5 year bond would begin rising. But since all mortgages are now qualified based on interest rates set in the bond market, it would nonetheless have the effect of constricting new credit entering the system. And with house prices at such extremes relative to incomes, and with savings rates at such paltry levels, people sure won’t be buying them at these levels without having access to cheap and abundant credit.
Said another way, if the cost and/or availability of credit were to constrict, to whom would current owners be selling to realize current prices? Maybe a wealthy, cash-toting foreigner if they are exceptionally lucky. But that wouldn’t be the fate of the vast majority.
The reality is that a soft landing in real estate is exceptionally unlikely. The balance of probabilities leans strongly towards a house price correction.