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:
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.