BMO’s housing outlook; Bond yields explode….mortgage rates will follow; Food prices set to rise

BMO releases draft housing outlook

Thanks to TH for sending this my way.  In keeping up with Scotia’s housing forecast released earlier this week, BMO has released a similar draft document:

Canadian Housing Outloook- 2011

Some key quotes:

Over time, home values increase with incomes.  Indeed, average resale prices and personal incomes both rose 5.7% per annum in the past three decades.  However, prices more than doubled (113%) in the decade to late 2007, and grew twice as fast as incomes from 2002 to 2007 (10.2% versus 5.0%).  Even after sliding 13% through the recession, prices quickly rebounded and are now 10% above their 2007 peak.

This is absolutely true.  It also holds that as house prices and incomes should approximate one another, the price/income ratio should be stable….not a rising and ‘sustainable’ trend as Scotia suggested.

The ratio of average resale prices to personal incomes is currently 14% above its long-run mean, suggesting the national market is moderately overvalued.

Now 14% is not an insignificant amount, but there is a huge unknown in this statement.  I interpret this to mean that they (as Scotia did yesterday) suggest that the national market is 14% above its long-term rising trend in price/income ratio?  It’s interesting that the Scotia used data back to 1980 to establish their trend line.  Yet if we strip out the past 10 years of massively expanding P/I ratio amid falling interest rates, loosening lending standards, and a society-wide embracing as the house as the ultimate investment, we find that the true long-term trend in price/income is remarkably stable.  This is true in virtually all Western nations.  While there were undulations over time, the long-term trend is stable…as it should be.  That all changed at the turn of the new millennium.  But that isn’t caught in the Scotia graph:

The great unknown is what happens if the housing market not only corrects back to its trend line since, but if the trend itself reverts back to its true long-term and stable mean.  If that happens (and history teaches us that it is very likely as there are very few true paradigm shifts), then the drop in house prices will be much more significant than 10-15%.

As I’ve noted, the next decade will look nothing like the past.  For one, we are entering a period of restraint in lending as mortgage criteria are being tightened.  We are also set to experience higher interest rates as they can not move meaningfully lower.  But the great unknown in all of this is how mass psychology will play out.  With consumer expectations so wildly divergent from those of our recent past, it’s hard to see how a realignment is not at some point in the cards.

More from the report:

Declining affordability coupled with elevated household debts should keep house prices on a tight leash. In addition to higher interest rates, demand will be restrained by a reduction in the maximum amortization period on insured mortgages from 35 to 30 years that takes effect March 18, which will raise the effective mortgage rate for the typical homebuyer by one-half percentage point and thus reduce affordability about 7%.

While demand will likely bounce ahead of new mortgage rules and rate increases (as was the case early last year), sales should subsequently cool and increase only modestly this year.

Not too much to disagree with except the extent to which sales might cool and just how tight of leash high debt loads will put on house prices.  There’s much more to the report, but I want to discuss a couple other interesting events from the day.


Bond yields explode….mortgage rates under upwards pressure

The 5 year bank of Canada bond yield, which sets fixed mortgage rates, jumped an astonishing 20 basis points today to reach its highest level since last May!  A basis point is 1/100th of a percent.

To understand why this is significant, it’s important to remember how banks make money.  In its most basic form, banks make the bulk of their money by borrowing from depositors at a low rate and lending at a higher rate.

Suppose someone deposits a bunch of money into a 5 year GIC at a bank. The bank will pay them a couple of percent but will look to re-lend that money out at a higher rate.

This is where the yield on the 5 year Government of Canada bond becomes important.  If the 5 year Government of Canada bond yields 7%, would they lend their deposit to someone for a mortgage at 5%? Clearly they would prefer to make the better return by buying the GoC bond. Bond prices and interest rates are determined in the open market. The BoC has no direct influence over the 5 year bond rate. Therefore, if a bank is considering lending you money for 5 years as a mortgage, they would at least make you pay the same rate they could obtain by purchasing a GoC bond with the same maturity length.

So what it amounts to is that this massive jump in yield will put pressure on the 5 year fixed rate mortgages, which are the mortgage product of choice for the vast majority of new home buyers.  Keep your eye on the rate of the 5 year over the next week or so.  If yields remain at these levels, expect the big banks to hike their posted rate another quarter percent before too long.


Food prices set to rise

Bond yields rise (and bond prices drop) with inflationary pressure.  So it’s perhaps no surprise that the massive bond yield spike comes on a day when George Weston, Canadian food producer, announced that it would hike prices by an average of 5% amid rising input costs.  Many food commodities have rise 35-50% over the past year.

The price increases are set to take effect on April 1.



This entry was posted in Economy, Real Estate and tagged , , , , , , , , , , , , , . Bookmark the permalink.

8 Responses to BMO’s housing outlook; Bond yields explode….mortgage rates will follow; Food prices set to rise

  1. jesse says:

    The move in bond yields is significant but it may just be normal moves. UST yields are up as well.

  2. Michelle says:

    Dear Ben:

    Thank you for your regular comments on the housing and general markets.

    I know you are in general, a deflationary guy. So am I! However, we are experiencing what I think, a temporary inflation due to global governments accumulation of debt….

    In that case, where do you see interest rates going in the short term, and long term.

    I am planning on buying 5year Gic at the end of this year. What do you think?



  3. Leo Lee says:

    The jump in bond rate today only pushed the rate back to where it was last week, when all the lenders moved their 5-yr rates up to about 4.24%. Some of them dropped their rates back towards the 4% level when bond yields dropped earlier this week as the situation in Libya worsened. What really happened today to cause the huge jump? Need to keep an eye on it tomorrow.

  4. backwardsevolution says:

    From yesterday’s post:

    Alex – good for you for going after Global TV for their one-sided analysis of the real estate market. I hope the CRTC takes this ridiculous reporting (or should we call it “advertising”) seriously and nails them on this. What a blatant attempt to help realtors suck in more buyers. Disturbing!

    Jacen – you mentioned economists “fudging” their numbers. Sadly, it is being done more and more every day. I guess it’s either that or lose their jobs; make everything look good or “less bad”.

  5. Howdy There says:

    The analysis of affordability is a good first step, but in order to understand the housing market a supply and demand analysis is needed. So here I go. 🙂

    When the price of a good rises more quickly than other goods it will tend to stimulate supply. We have seen this in housing; there have been more houses going up than there are end users. Normally the increase in supply would put downward pressure on prices, as sellers compete by cutting prices in an oversupplied market.

    But housing is special. The demand side responded to price increases by demanding more, in expectation of further price increases. Investors purchased inventory some of which went without end users, either being held while renovations were done or just until sold. Or they end up being rental units, some of which aren’t rented. The combination of units not occupied (either for sale, not yet for sale, or unrented) represents a subset of the demand side of the equation which absorbs the excess supply.

    Looking at the affordability trendline only allows the bank economists to predict only moderate price decreases. What they overlook is the unoccupied investor held inventory. Once price increases fall far enough, investment activity will drop significantly decreasing the investment portion of the demand equation. This lessening demand will put downward pressure on prices.

    The second factor is demand timing. Falling prices in the housing market, once recognized by the general public, will shift the psychology of buyers. Recent history has seen a ‘buy now or get priced out forever’ mentality. The best time to buy was right now. The flexible portion of the demand side is pulled forward. As psychology shifts, the flexible will push their demand back hoping for even lower prices. For instance, recent university grads may decide to stay with their parents longer delaying a household formation. A couple looking to split apart may delay waiting for housing to settle out. Potential move-up buyers delay their move, so while the number of households stay the same, they don’t free up an affordable house for potential first time buyers. All this together puts downward pressure on prices.

    Later all.

  6. Village Whisperer says:

    The reaction to bond rate numbers reminds me of the reaction to Quantitative Easing last year. No one could (seemingly) see the inevitable connection to cost-push inflation with QE. Now no one sees the alarm bells that should be going off as the next dominoes start to fall and bond rates start rising (except Carney and Flaherty… they see it and have been trying to cover their butts by warning everyone since last year).

    It’s why these bank reports will become nothing more than birdcage paper. Stagflation has returned and rising interest rates will not be offset by a booming economy.

  7. Dave says:

    Interesting headline on about the Vancouver housing market, the article was originally printed in the Vancouver Sun.

    I liken articles like these as the harbinger of tops of markets. By the time the media picks up the story it is usually the top or bottom of any market.

    Just like the stock market when the news is all over how high it is then that is a sure sign of the top, likewise when they report nothing but doom and gloom then that is the bottom.

    I also might add that the H.A.M. is the last money pile into the market, I liken it to getting the stock tip from the bus driver/barber. Once the bus driver / barber has his money into the stock market all buyers are now in.

    I agree with Ben I was at a meeting 2 days ago with some real estate guys that are dead set in thinking 1 br. condos in Coal Harbour will soon be $1,000,000.

    Unfortunately or fortunately the real estate market is fairly ill-liquid and therefor moves down slowly unlike the stock market.

  8. Pingback: Valdao Reputo – Worthwhile Links (March 5 2011) » Valdao Reputo (VR)

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s