Canada's Housing Bubble

Jun 28, 2010  Ethan Rabidoux rabidoux.tumblr.com

Howdy all,

I posted Chris Martensen’s video yesterday about Fractional Reserve Banking. My brother wanted to emphasize a couple of huge shortcomings in the FRB system;

1) There is never enough money in the system to pay off existing debt, meaning a perpetually expanding debt base is needed. It is a Ponzi scheme at its finest

2) It means the entire financial system operates on a knife edge. A loss of confidence that causes 5% of depositors to ask for their money back causes systemic collapse barring government intervention.

Watch the video again. Make sure you understand this to understand why our politicians are full of it.

Meanwhile, Ben also wrote up a perfect outline of why our economy faces a deflationary recession wallop. It ties in nicely to yesterday’s video. Enjoy!

Ethan Rabidoux

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Not too much on the data front with regards to housing in particular.  Not surprisingly, some of the big banks are once again cutting their fixed rate mortgages.

As I’ve said all along, I was surprised that the Bank of Canada raised rates and I expect them to stay at extreme lows as long as deflation stalks the landscape….which should be a while. That brings us to the topic of this post.

I want to once again reiterate my perspective of the macro picture which will provide the backdrop to the coming housing correction.

Without this macro-level backdrop, I would still be inclined to believe that housing has risen too far too fast, having massively outpaced both income gains and inflation for a decade.  In this light, it’s due for a correction regardless.

However, what I see on the horizon turns what should otherwise be a run of the mill housing downturn into a potential crash that could stun even the most ardent bears.

Remember that I have long maintained that deflation and not inflation will dominate the near future, much to the shock of everyone, as inflation has been a given for so many years now.

The repaying of debt and a new consumer frugality are in the cards.  This will be the natural by-product of even a modest housing correction. Heck, even without a housing correction it’s hard to imagine how people can continue to amass debt and neglect savings for much longer barring the reemergence of significant inflationary forces (not gonna happen).

For those who understand money creation and destruction (see yesterday’s blog post about money creation in a fractional reserve banking system for a brush up), this will have the effect of slowing the velocity of money and shrinking the aggregate money supply, which constitute the two factors that create inflation.

Despite how the Bank of Canada calculates inflation (the rise in prices as shown in the ‘Consumer Price Index’), inflation is not defined as a rise in prices at all. That is the most obvious symptom of inflation but would be akin to defining a cold as a runny nose. The runny nose is once again the symptom.

In the words of Milton Friedman, “inflation is always and everywhere a MONETARY phenomenon”.  In other words, it is the result of the aggregate money supply multiplied by the speed at which that money changes hands.

As one or both of those factors increase, assuming a stable supply of goods, the value of those goods rises accordingly.  THAT is inflation.

Consumers are at the point where they must begin paying off their debts.  Debt in Canada has never been higher, currently sitting at almost 150% of disposable income.

The effect of this is two-fold:  It reduces the money supply as that debt is retired, and it also hurts ‘economic’ growth in North America, which has been 70% dependent on consumer spending (we’ll revisit that shortly).

The other effect that is in the cards is an increase in the savings rate. Currently we are sitting at about a 2.5% savings rate in Canada. This is well below the 10% of a decade ago and is a country mile from the 20% savings rate in the 1980s.

As this savings rate inevitably increases, money starts to change hands more slowly, leading to a slowing in the velocity of money.

Now for a simple but powerful equation to help you understand the effects of falling money supply and velocity:

MV=PQ
Where: 
M = The money supply
V= The velocity of money
P= The price of money in terms of inflation or deflation
Q= The quantity of production, or GDP

If we increase the supply of money and velocity stays the same, and if GDP does not grow, that means we’ll have inflation, because this equation always balances. But if you reduce velocity (which is happening today) and if you don’t increase the supply of money, you are going to see deflation.

This is where central banks step in to ‘stimulate’ the economy via money printing (quantitative easing) in an attempt to increase the money supply. However, this has its limits too as consumers will reach a point where they would rather save the newly printed money, use it to pay off existing debt, or where banks desperate to sit on their cash for future loan loss provisions refuse to lend.

A trillion freshly minted loonies buried in a pit do not cause inflation. Nor do a trillion loonies sitting in a bank account or a trillion loonies used to pay off debt. This is what is happening in the US right now, which is why trying to stimulate an economy in the midst of a debt deflationary cycle is akin to pushing on a string.

Japan has been pushing on their string since the 80s. Despite rock bottom interest rates and quantitative easing, home prices are 80% below their 1980s peak (yes you read that right….80%) while the stock market is 75% below its 1980s peak.  Can it happen here?  Maybe…..maybe not. Some people will insist that we are different.  Ask them to explain why.

The point is that deflation is a powerful monetary phenomenon that can become self-feeding, difficult if not impossible to remedy, and absolutely ravages leveraged assets.  This is our future.  Bank on it.

The bond market certainly is banking on it. Remember that the bond market is 14 times the size of the stock market and governed overwhelmingly by ‘sophisticated’ investors. If inflation is a concern, bond investors demand more of a premium, as the money being repaid to them in the future is inflated money with each dollar buying less.

In a time of inflationary pressure, bond yields sky rocket. The opposite is true of deflation. Times of deflation mean that money being returned in the future is MORE valuable, so less of a risk premium is demanded.

So what does the bond market see in the future?

Check out the first graph showing the yield curve on US bonds.

You’ll notice they hit rock bottom in January 09 before the stimulus sugar high kicked in, sparking the great reflation of 09. Now that the artificial high is wearing off, what is in the response of the market? Check for yourself.  Yup…no inflation in sight means collapsing yields.

If you have to make a bet based on what the bipolar stock market or the bond market is telling you, bet with the bond market. This is why interest rates should stay low for some time.

The caveat all along has been that a loss in confidence in the ability of a government to repay its debt by taxing its citizens (a la Greece or Spain) would also cause bond holders to demand a risk premium. That is not in the cards in North America YET.

Now, I want to reiterate my stance on the economic ‘recovery’. I have always maintained that absent massive stimulus spending, there is no recovery and we are still in a recession (more technically a depression as I view a recession as a business cycle event where a depression is a debt bubble event, but I digress).

You have all heard me say before that there is no recovery until we stop artificially stimulating the economy and begin paying off debts at the government and personal levels and STILL see growth.  Otherwise it is simply a mirage.

Now that stimulus is starting to wear off in the US, what is happening?  Perhaps the best gauge of coming economic activity is the ECRI (Economic Cycle Research Institute) Weekly Leading Indicator Index. It is made up of a number of complicated components such as corporate yield spreads, initial jobless claims, home purchase index, etc.

I have attached the weekly ECRILI chart as of June 11.

You’ll note the rate of collapse. It is at -5.9%, down from -3.9% the week before.  Why is that significant? Well, a drop of that magnitude was present prior to all 7 of the previous recessions.

A drop of 10% has preceded a recession 100% of the time over the 42 year history of the ECRI. We should breach that level by July if this trend continues.

Bottom line: The recession will be back in the US by Q4 2010. Given our reliance on the US consumer and the inevitable bursting housing bubble, we should be back in recession here in Canada by Q3 2011.

The media may call it a separate recession, but you know the truth.

For that matter, the stimulus-induced bounce in housing should be long gone by that time as well, resuming the free fall that should have continued from late 2008 and early 2009.