Ed’s Cry for Help – Are More Changes to Mortgage Rules Coming?January 5, 2011
Mortgage Rules Changes for 2011: What They Are, Why They Matter and How They’ll Be Good For Us…in a Brussel Sprouts Sort of WayJanuary 26, 2011
The world’s economies are continuing their clean-up efforts after the bursting of the global credit bubble. Like a giant oil spill, the impact has been pervasive, the true costs to repair the damage are unknown, and all of the long-term repercussions are impossible to predict, let alone quantify. The overall recovery continues to sputter along because the world lacks the positive catalyst it needs to rebuild global economic momentum and growth. This is mainly because its three largest economies, the U.S., the EU and China, are all vulnerable at the moment. Canada, meanwhile, has continued to put up numbers that are the envy of the developed world, but our momentum has started to slow and we don’t yet know if our economy will sustain its current trajectory as our government winds down its various stimulus measures. Today’s post, my quarterly mortgage market update, will touch on how unfolding events in the world’s three largest economies are likely to impact Canada, and more specifically, our interest rates. I’ll then offer some insight into recent developments here, before closing with my usual recommendations on both fixed and variable rates going forward.
In the land of the free and the home of the brave, where Canada sells about 80% of its exports, the struggles continue. A recent Bloomberg Business Week article noted that U.S. home prices have tumbled 30.5% from their high in April 2006, according to the S&P/Case-Shiller index as of October 31, 2010. That matches the drop in house prices during the Great Depression including the period from 1925 to 1933. What’s more, many believe the U.S. housing market has farther to fall. To cite one example, check out this detailed analysis by Dr. Gary Shilling, a widely respected analyst with an impressive track record who makes a compelling case for another 20% drop in U.S. house prices over the next several years. Housing is critical to the U.S. recovery, because it has led the U.S. out of seven of the last eight recessions.
U.S. unemployment levels remain worryingly high. Even positive news on this front, like the December jobs report that showed unemployment dropping from 9.8% to 9.4%, has to be taken with a grain of salt. In this instance, of the 556,000 people who left the unemployment roll, 260,000 of them did so because they gave up looking for work. The real story here is that unemployed Americans are staying out of work for increasing lengths of time, with the average period of unemployment now at 34.2 weeks. The longer the unemployed stay off, the harder it is for them to reintegrate into the work force and the greater the cost to taxpayers. This ‘hardening’ of the unemployment rolls is an expensive and long-term problem that isn’t going away soon.
The most troubling U.S. statistic is that the federal government is spending $1.60 for every $1 of tax it generates. It’s just hard for me to get optimistic about future growth rates in the U.S. when their economy is being supported by unsustainable levels of both monetary and fiscal stimulus (by proportion, its fiscal deficit is comparable to that of Ireland and Greece). To put it another way, when Federal Reserve Chairman Ben Bernanke says that the U.S. economy cannot sustain itself without its current stimulus programs, at the same time as the Republicans are swept into office promising to slash spending by $100 billion this year, something’s gotta give. Meanwhile, many state and municipal governments are facing budget crises, some in the billions of dollars, and the federal government isn’t riding to the rescue this time (perhaps it knows it can’t). With the risk of state and municipal defaults rising, investors will demand higher yields, raising both the cost of borrowing and, by association, the size of the deficits themselves. The risk, from a Canadian perspective, is that as bond market fears of default escalate, the pain of higher yields will probably spread, at least in part, to healthier economies like ours (more about this later in the post).
With the U.S. on the ropes, commodity-based economies like ours look to China, and its voracious demand for resources, to pick up the slack in world demand. While Canada sends only about 6% of its exports directly to China, this country has accounted for all of the incremental demand that has led commodity prices higher during this cycle, and because commodities are sold at world prices, Canada benefits from Chinese demand even if China is not usually our direct customer. Unfortunately, fears of Chinese real estate and credit bubbles are growing, and even though the Chinese government can exert much more direct control over its banks, companies and citizens, you can only kick the can down the road for so long. A report I read recently called “Shadow Over Asia” by Vitaliy Katsenelson, in The Casey Report (October 2010 Volume III, Issue 10), had some surprising data. For example, China is counting projects like the building of Ordos, in Inner Mongolia, in its growth numbers, but this city, built for 1.5 million people, sits empty (check out these slides to see for yourself). Spending on projects like this shows up in the numbers as “growth” but in reality, this spending isn’t providing any sustainable economic benefit. The South China Mall is another example. It is the second largest mall in the world, but has fewer than a dozen shops operating in an area with over 9.6 million square feet of floor space.
On the residential side, the property-value-to-income ratios for Beijing and Shanghai are 15 and 12 respectively (at the peak of the Japanese real- estate bubble, Tokyo’s ratio was 9). In his paper, Katsenelson cites a recent study showing that 64.5 million apartments don’t have electricity bills because they are unoccupied. Meanwhile, property investment in China has climbed to 10% of GDP, whereas it never exceeded 6% in the U.S. during the housing bubble. I mention all of this to make a simple point. If the Chinese economy were to experience an exogenous shock, say a dramatic decrease in export demand from the U.S. and EU markets, there is a significant risk that its growth rate, and its demand for the world’s commodities, could slow dramatically.
This brings us to the EU, where sovereign-default risks abound. After accepting a bailout package that would saddle its citizens with severe fiscal austerity measures for a generation or more, the Irish government has the makings of a revolt on its hands, just in time for its general election, which looms in early 2011. The main Irish opposition party is promising to reject the bailout and opt for default instead, and if Ireland falls, what of Greece, Portugal, Spain, and Italy? As mentioned above, large-scale defaults can send bond yields, and borrowing costs, soaring – even in otherwise healthy countries, like ours.
Back home in Canada, the news isn’t as dire but our economic data are still a mixed bag. To wit, while we have restored all of the jobs lost during our recent recession, many of the full-time jobs have been replaced with part-time jobs. Also, while our unemployment rate has been dropping, it was at 7.6% as of December 2010, which is still well above our long-term average of 7%. Our output has returned to pre-recession levels, but our rate of GDP growth, which was 1% in Q3, 2010, is trending down. Inflation is well under control, with our November2010 Consumer Price Index (CPI) coming in at 2%, and our capacity utilization rate at 78.1% in Q3, 2010 (it starts to look inflationary in the low 80% range).
Most worrying is our trade deficit, which is the highest it’s been in 20 years after reaching a record of $2.44 billion in July 2010. A trade deficit happens when we are importing more than we are exporting, and in simple terms, it means that our economic production is not globally competitive. In a related point, Canadian productivity, which is a measure of how efficiently our goods and services are produced, has consistently lagged against other western countries, and it will be the single most important determinant of our per capita income growth over the long term. Consider that despite all of its other troubles, U.S. productivity has improved during their Great Recession, and that the gap between Canadian and U.S. productivity levels continues to widen in their favour. We might want to keep that in mind if any temptation towards Schadenfreude arises.
I Think Variable Rates…
aren’t going anywhere fast. Our central bank recognizes that our delicate recovery still needs low, stimulative rates to foster continued growth. In fact, the only real pressure for raising rates in the near term was related to our record and rising personal debt levels, and this risk was significantly and intelligently addressed by the federal government’s three changes to CMHC’s mortgage insurance rules yesterday (my topic for next week’s post). Also, inflation is well under control, and the Canadian dollar is flirting with par against the greenback. As we have mentioned in previous updates, a rising currency decreases the costs of our imports and slows our rate of inflation, so in that sense, our appreciating dollar is already akin to additional rate increases. If we raise rates in the future while the U.S. stands pat, we will experience the double whammy of higher borrowing costs and a higher dollar. This is a significant factor in my overall view that short-term rates are a good bet while the U.S. recovery continues to run its course.
Having said that, I do think there are significant inflationary risks over the medium- and long-term as the newly printed money in the U.S. (and to a lesser extent in Canada) continues to circulate its way through the economy. When inflation does arrive, it may do so with surprising speed, so variable-rate mortgage borrowers should keep their eye on the interest- rate markets or partner with an experienced mortgage planner who will do it for them.
I Think Fixed Rates…
are expensive right now. While the five-year- fixed-rate mortgage is priced at 3.89%, the equivalent variable rate can be had for 2.25%, which is a difference of 1.64%, or almost half of the fixed rate. That’s a significant premium to pay for rate stability, but if you’ll lose more sleep worrying about what rates are going to do than you will worrying that you’re paying too much interest, then a fixed-rate mortgage may still be the way to go.
One more thought for those inclined to take a fixed rate. While the risk is still remote, if countries like Ireland or a few states in the U.S. start defaulting on their debts, interest rates everywhere could rise quickly and sharply as the contagion of investor fear spreads. If this did happen, my fixed- rate mortgage holders would be very happy with their locked- in rates, no matter the premium over variable rates.
With so much uncertainty in the global economy, it’s even more difficult than usual to predict what the future will hold. Are we in for a long period of subdued growth as the world continues to deleverage its way back to fiscal solvency? If so, variable rates should stay low and fixed-mortgage-rate premiums will look very expensive in the rear view mirror. Or will increasing credit default rates and/or sharp increases in inflation, however unlikely they seem now, have variable-rate borrowers locking in at whatever rate they can get their hands on? On balance, I think that short-term rates will stay low for the foreseeable future, and I think the savings that can be achieved with variable-rate financing make this option worth the risk (provided that borrowers are comfortable with, and can afford, higher payments).
Here’s hoping that my coming Spring mortgage market update brings a clearer picture along with some melting snow!