Upper Body Work on the Five Year

Here are some graphs on the Canadian five year mortgage rates. The first graph is the "posted" and "average" mortgage rates since around 2000:

The components of the mortgage rate are comprised of future inflation expectations (I used the long real return bond and the long bond to estimate future inflation expectations), the real rate of interest on "risk free" (the five year Government of Canada bond yield subtracting inflation expectations), and the residual which we abstract to be the "spread".

The real rate of interest on the five year GoC bond has been negative for over a year now. For the most part this has materialized as increased spreads to mortgage lenders and securitizations. The negative real rate on the five-year bond has been causing consternation with the government and the Bank of Canada and is a major reason why they have been leaning so heavily on mortgage lending over the past year.

The posted and average mortgage rates have diverged over the past few years:

Finally there is the "renewal gap" that takes rates from five years ago and asks the question, what interest rate differential (IRD) will a borrower see upon renewing a five-year mortgage, all else equal? I have estimated the forward-looking renewal gap by keeping current rates constant out until 2018 (five years from now). If that occurs the renewal gap in five years will be exactly zero.

The five-year renewal gap is heavily negative and will remain so until the end of 2013. This will provide some refinance tailwind for housing activity. That tailwind hits a proverbial brick wall in 2014 even if rates remain low. (Note the absolute magnitude, not just the gap, matters for payments. That is, a renewal gap of -1% pre-2008 and post-2008 will have a different effect on changes in absolute payments.) In terms of setting macroprudential policy, I expect the government is considering upcoming renewal IRDs.

The Soft Landing Platitude

Much talk about a so-called "soft landing" of house prices -- where prices do not significantly fall on an annualized basis and incomes and rents increase to return valuations historical affordability or earnings ratios -- has been around recently with various banks warning markets like Vancouver's may be in for a large correction.

To test what would be required to manifest a "soft landing" I have taken the July detached benchmarks from 1999 until 2010 and adjusted them for inflation. Then taking the July 2011 benchmark as a baseline, determined what annualized % gains or drops would be required to return prices to previous years' inflation-adjusted valuations. I have assumed 2.5% annualized inflation.

In other words: what annualized gain or loss would be required to return prices to a given past year's valuation in a given future year? The results are as follows:

The way to use this chart is as follows. Say you think (or hope) prices will return to a certain past year's valuation (year Z) some point in the future (year X). Find year X on the x axis of the above graph and then find the colour of the past year Z of interest to find out what annualized gain or loss is required for that condition to happen.

For example say I want to know what annualized drop is required to see 2004 prices in 2018. That would require a compounded 4% drop in prices starting 2012 until then (i.e. 4% drop from 2011 to 2012, 4% drop from 2012 to 2013, etc.). For a $800,000 property that means its value will be nominally $626,000 in 2018.

(The base condition of 2011 valuations is a straight line because if one assumes 2011 is the "new normal" then prices will appreciate each year at the inflation rate. Thus, for 2011 valuations to hold in 2012, there should be a 2.5% increase year-over-year.)

I have included the absolute price change graph as well for completeness. Many people will look at absolute, not annualized, returns so here you go:

I don't know exactly how pundits define "soft landing" but whether they realise it or not they are hoping that more recent prices are indicative of new valuations. If it turns out inflation-adjusted prices from years closer to the turn of the millennium are the end destination, as they turned out to be in many parts of the United States, I'm not seeing anything approaching a "soft landing".

Carney says a four letter word

Vancouver's aspirations to become like New York took a big step up today with a feature article in bloomberg: China Buyers Make Vancouver Pricier Than NYC

Buyers from mainland China are leading a wave of Asian investment in Vancouver real estate as China tries to damp property speculation at home. Good schools, a marine climate and the large, established Asian community as a result of Canada’s liberal immigration policy make Vancouver attractive, said Cathy Gong, who moved from Shanghai to the Shaughnessy neighborhood on Vancouver’s Westside about three years ago.

“The schools here are the best and there are a lot of Chinese people here,” said Gong, whose son is in sixth grade at Shaughnessy Elementary School. Eastern Canada wasn’t an option because “I cannot bear cold weather,” Gong said. Vancouver has the second-largest immigrant Chinese population in Canada after Toronto.

The usual arguments of Vancouver's attractiveness, good schools, temperate climate, large Chinese community, and favourable immigration policies are cited as reasons for the high level of investment in Vancouver real estate. Of course the article fails to mention how, even after the multiple "waves" of Chinese immigrants over the years, the majority of homeowners and homebuyers are still local.

Anyways, the Bloomberg story is fun for discussion but not to be outdone, Bank of Canada Mark Carney gave a speech today on the shifting sands of the global economy. Although drier than Bloomberg, I tend to pay more attention to what Carney says, given the power and influence the Bank possesses over Canada's economy. Of particular interest to Vancouver housing market enthusiasts are the following quotes, first on capital flows (emphasis mine):

While emerging economies are having difficulties absorbing large private flows, advanced economies have often misallocated surges in yield-insensitive gross claims. In Canada, as elsewhere, large capital inflows will require vigilance from public authorities and private financial institutions. Financial history, particularly during times of large power shifts, is rife with examples of booms stoked by dumb money that turn good situations to bad.

And then on inflation risks:

The possibility of greater momentum in household borrowing and spending in Canada represents an upside risk to inflation in Canada. The persistent strength of the Canadian dollar could create even greater headwinds for our economy, putting additional downward pressure on inflation in Canada.

How does these statements segue with the Bloomberg article? Well it's hard to completely understand the context of Carney's statements regarding capital flows. If, for argument's sake, we were to look at the investment in Vancouver real estate in the past 5 years due to immigrants and nationals from Asia, we might start thinking that, on a cumulative basis so as to make it into a tangible and sizeable economic entity, Vancouver real estate might actually be drawing the attention of policy makers. Based on that inference alone it seems like articles like the one from Bloomberg are not going unread in the halls of Ottawa.

As I mentioned in a previous post, it looks unlikely that nation-wide action to further subdue household credit through CMHC policy changes is likely, with much of the country apparently cutting back debt growth. Two regions -- Vancouver and Toronto -- seem to be showing an immunity to debt curbs as prices continue to increase in the face of low yields -- i.e. "dumb money". Though it's wild speculation (as it were), I would not be surprised to see some targeted efforts to reverse price increases in both Vancouver and Toronto, markets that are annoyingly distorting the nation's house price figures.

Global Rebalancing

Concerted discussions by G20 countries to formulate a cohesive monetary policy are slowly at work. Recent comments by Bank of Canada Mark Carney on high levels of capital flows, a demand-driven commodity boom, emerging market inflation, and the transfer of such inflation to developed markets like Canada's, supposedly gave stock markets a reason to take pause earlier this week.

An interesting article by Manoj Pradhan and Alan M. Taylor of Morgan Stanley argues that the "global savings glut", where capital flows to emerging markets (EMs) return "uphill" to developed markets (DMs) in the form of asset purchases, are unlikely to continue at previous pace.

Capital flowed “uphill” from poor to rich countries — EMs saved more than they invested, the excess showing up as current account surpluses (net exports of EM goods) and financial outflows (net acquisition of DM assets). But digging deeper exposed a crucial fact: private capital still flowed “downhill” to EM economies in line with intuition, but offset by even larger “uphill” official flows, the reserves bought by EM central banks and sovereign wealth funds.

...

While EM reserves might still grow gradually to track EM expansion, a continued aggressive step-change to augment reserves relative to GDP seems unlikely, as current war chests are evidently large enough to cope with severe macroeconomic disasters.

Why is this important for Canadian housing? It's not a coincidence that low interest rates have been helped by increasing demand for treasuries by those abroad who have saved. If their saving patterns look to be shifting into investment, that should produce higher interest rates for government debt.

The article concludes:

...we see lasting consequences beyond those unfolding in the immediate aftermath of the financial crisis:

• A huge rise in demand for capital in EMs with a more moderate increase in DMs. Talk of a savings glut or an investment drought may recede. The global real interest rate is likely to rise.
• Less saving flows out of EM economies. Growth prospects are the main driver but risk premia for newly resilient EMs may fall. If investment demand is muted in DMs, and saving flat, the shift is weaker in DMs. Global imbalances moderate, reinforcing the trends after the crisis.
• These current account shifts cannot be an “immaculate transfer” without real exchange rate adjustment. Recent real appreciation of EMs took the form of relative inflation and managed currencies (the latter creating political distractions). But EMs are likely to absorb further adjustment through nominal appreciation, given a triple whammy of cyclical reflation, growth differentials pushing nontradable inflation and oil/commodity price shocks.

Despite ongoing developed world unemployment issues, high commodity prices, and serial developed world sovereign debt crises, it's useful for us to remember the global economy will eventually start to recover in earnest and pay more attention to productive investment, and this can happen relatively quickly.

Housing Market Sensitivity to Interest Rate Changes

In an efficient housing market, we should expect a house to behave somewhat as a bond or dividend paying stock would with the par value / selling price of the home changing to reflect the market rates that apply to the asset and the expectations about future rates. Since homes are largely purchased with borrowed money and capital should move to the optimal risk/return relationship, we should expect this relationship to exist, in some form.

Now we might argue that the housing market is not efficient and while this may be true over short and medium time horizons, no market can behave inefficiently (gross over/under valuation) over longer time horizons and certainly not forever.

Let's use a simple example:

Bob's house could sell for $1,000,000 today.
It could rent for $36,000 per year.
The gross yield is 3.6% - similar to what could be earned on a 10 year government bond. We can use high quality bonds as a proxy for the rate of return we should expect on a house - government and agency bonds are very liquid and very safe.

Let's assume that for whatever reason (inflation expectations, competing returns, currency devaluation, etc) the yield rises to 5% and the rent stays the same. What will Bob's house be worth in the new environment? House Value * 5% = $36,000 or House Value = $36,000 / 5%
The house would be worth $720,000 in the new return expectation environment.

This may bring up a valid question: What if rents rise with inflation? Good question, keeping in mind all that is required to move the bond market is EXPECTATIONS about inflation and not inflation itself, so the idea of rising rents correlating with expectations about inflation may be questionable. Rising rents require rising wages and there can be a significant lags between inflation expectations and wage increases.

Assuming rents rise over 10% to $40,000, let's use the example above where return expectations are now 5%. House Value = $40,000 / 5% The house would be worth $800,000 in the new return expectation environment.

These examples are grossly oversimplified with many unaccounted factors. We can crunch the numbers all day long but what I have intended to show is that in a rising rate environment we can expect house prices to fall to meet expectations about the return required on an investment. What we have experienced since 1982 is a falling rate environment where 10 year Government of Canada bond yields have fallen from over 16% to under 4%.

Assuming $40,000 annual gross yield:
House Value at 4% = $1,000,000
House Value at 16% = $250,000

Can interest rates fall from the current level? Are they more likely to rise? Will they stay the same? What about inflation expectations? What will the market's reaction be to inflation expectations?

If you want the current level of house prices to be maintained then you should be hoping for inflation expectations to remain low, that rates stay low, and that rents keep pace with incomes for a very long time. This probably would not bode well for economic prospects and consequently incomes and rents but alas you cannot have your cake and eat it too!

This chart shows home prices correlated to mortgage rates. You can see that when mortgage rates were much higher, home prices were much lower and that when mortgage rates have been lower, home prices have been higher. There is a lower bound to mortgage rates but no upper bound so you could say that the risks are lopsided.


Disclaimer: I am not pretending that we should value all homes like a bond or stock since clearly there are other factors at play such as densification, gentrification, decay, depreciation of structures, among other potential rewards and risks (real estate is not fungible). Additionally, rents can rise and fall unlike bond coupons which remain constant until maturity. The dividend discount model may be a good way to value a home based on cash flows but it can get pretty complicated and we must assume growth factors which is tricky at best.

The "Inflation Hedge"

Much talk has ensued in past months, around the time of quantitative easing by central banks, about the concept of real estate being a so-called "inflation hedge". What is meant by this?

The concept of "hedging" is pretty straightforward: take a position in an investment that limits the possible losses when summed with another investment. Generally one gives up some return for doing this but one can prevent against an investment being wiped out. Of course in the context of real estate, there is no hedge per se. What is meant is that real estate returns generally track inflation. Therefore if you have investments that would be hit hard if inflation increased, real estate is purported to generally increase its total return in an inflationary environment and you would at least have something, all said and done.

It helps to remember, when it comes right down to it, why real estate has any value at all. Simply, real estate is a capital asset that generates income from rents. Without that income or potential income (tangible or intangible), real estate would have no inherent value. It so happens that rents generally increase with inflation so the future value of the asset would tend to increase with inflation as well, minus depreciation of course.

The problem with blindly touting real estate as an "inflation hedge" is that the cash flows eventually determine prices. If prices are out of line with cash flows, what fundamentally justifies prices increasing with inflation? Often it is taken on blind faith that real estate prices increase with inflation as a law but prices are dependent upon the cash flows -- prices do not rise in and of themselves without cash flows rising as well. Unless there is speculation.

In a speculative bubble, where yields from cash flows are poor compared to other similar investments, it is not true that prices generally appreciate with inflation. In such an environment the balance of probabilities will have prices trail inflation at least until the underlying income streams are competitive again. You would be better off investing in real return bonds or perhaps some of the countless other investments whose income streams track inflation as well, many of which may well have better risk-adjusted returns than that condo with a 4% cap rate.

Behind the Food-Price Riots

From the Wall Street Journal: By VINCENT REINHART, April 18, 2008

With a dramatic rise in the prices of foodstuffs, riots have flared up in dozens of hotspots around the world. Panicky politicians are responding with precisely the wrong policies, including production subsidies and trade controls.

The problem is clear enough: According to the International Monetary Fund, food and beverage prices have risen 60% in the past three years, and more than doubled since 2001. Even in the U.S., increases in the food-price component of producer- and consumer-price indexes over the last 12 months have been in the neighborhood of 5%.

What is going on? We can discern four forces at work today pushing up food prices – forces that were also at work in the 1970s, the last time food prices increased so rapidly on a sustained basis:

- Monetary policy in overdrive. Consider the real federal funds rate – that is, the nominal funds rate less inflation. A low real fed funds rate both encourages interest-rate sensitive spending, such as business investment, and discourages global investors from supporting the dollar on foreign exchange markets. At 2.25%, the nominal fed funds rate is now below the prevailing rate of consumer price inflation.

The last time the real fed funds rate was negative for a prolonged period was the mid-1970s. This was also a period when overstimulated demand pushed food prices up and the dollar depreciated sharply. In the end, economic growth suffered as well. Remember stagflation?

- Exchange-rate arrangements in disarray. The 1970s were also noted for turmoil in exchange markets, following the breakdown of the Bretton Woods system. The schism today is that some exchange rates move too little and others too much.

The exchange rates that are moving too little are those of emerging market economies and oil producers. China, India, Korea and Taiwan, and key oil producers such as Saudi Arabia, have been preventing their exchange rates from appreciating significantly by rapidly accumulating international reserves.

They've also effectively adopted the monetary policy of the Federal Reserve by keeping their domestic interest rates close to the fed funds rate. That way, no interest-rate wedge opens between their markets and our own that would otherwise put pressure on their exchange rate. As a consequence, they are following an accommodative monetary policy strategy totally unsuited to their already overheated domestic economies. Higher inflation has followed.

With exchange-rate movements capped by policy makers in so many parts of the world, the burden of adjustment falls more heavily on the nations that allow their currencies to float freely, such as Canada, those in the Euro area, and Japan. The depreciation of the dollar against these currencies is yet another reminder of the 1970s. As a result of these exchange-rate changes, the purchasing power of these regions for any internationally traded good denominated in dollars has gone up. Hence, it is no accident that the dollar price of food is up sharply.

- Unsound market interventions. Policy makers flailed about in the 1970s, enacting environmental legislation without due deference to the costs imposed on industry. They also tried to impede market forces with gasoline rationing and a brief flirtation with outright price controls.

This time round, our government has been force-feeding the inefficient production of ethanol. The result: Corn prices have more than doubled over the past three years, adding to price pressures on commodities that are close substitutes, or which use corn as an input to production.
Meanwhile, policy makers in emerging market economies have bent under the weight of popular unrest to raise food subsidies. This strains their budgets. They are also imposing restraints on exports, thereby losing gains from trade.

- Oil prices on the rise. The lines stretching around filling stations in the 1970s should remind us that large energy-price increases are disruptive. And we have had a large one: Crude prices have more than quadrupled since 2001. Any industry dependent on energy will feel those cost pressures, and modern agriculture, with its oil-based fertilizers and large machinery, is no exception.

But there is an important difference between our troubles today and those of the 1970s. In that decade, aggregate supply sagged as oil producers scaled back production and anchovies disappeared off the coast of Peru. The 2000s have been about demand expansion. Millions of workers in China, India and Vietnam, among others, have joined the world trading system. Beginning from a point close to subsistence, most of their additional income is being spent on food. Thus, the price of food relative to other goods and services has risen.

The good news is that producers respond to relative prices, although it can take some time. Already, the acreage in which corn is planted in the United States is back to levels of the 1940s. More of a production response should follow in other areas as well.

Challenges abound as supply catches up with higher global demand. The Federal Reserve has to be sensitive not to stoke inflation pressures, and to monitor inflation expectations closely. The subsidies proffered to corn producers have to be trimmed, in part to set a new standard for emerging market economies to emulate. And the gains from an open trading system have to be protected to keep our economy efficient.

Mr. Reinhart, a resident scholar at the American Enterprise Institute, was director of the Division of Monetary Affairs at the Federal Reserve.

Here is a Canadian perspective on inflation.

RBC Economics Report

No time to do a post today so here is a RBC Economics Report that outlines some of the reasons for today's market action. These bad numbers were in addition to the massive asset writedowns at Citigroup and CIBC. Interesting times indeed.

U.S. retail sales growth dropped 0.4% in December
Rishi Sondhi, Economist

U.S. retail sales growth dropped 0.4% in December, a much weaker result than the market’s expectation of flat sales. However, the sales decline was following a very robust, although downwardly revised, 1% gain in November. Ex-autos, sales were down 0.4%, again weaker than expectations.

The drop in retail sales in December was, in part, attributable to nominal sales at gasoline service stations dropping 1.7%. However, this partly reflected a decline in gasoline prices. Excluding this component along with the volatile motor vehicle and building material components, sales were actually up 0.2%, building on November’s downwardly revised 0.8% gain (previously reported at 1.3%).

The portion of retail sales that feeds into quarterly spending — retail sales ex autos, building materials and garden equipment, and supply stores — fell a slight 0.1% after surging 1.6% in November. During the November-December holiday period, sales were up 0.3% on average, compared to 0.7% in 2006 and 0.4% in 2005.

The U.S. retail sales figures are consistent with a drop in real spending in December, which we currently estimate to be -0.1%. Despite the likely decline, November’s real spending surge makes it highly likely that spending will come in above 2.5% in the fourth quarter. Slower spending in December does suggest somewhat softer spending momentum heading into the first quarter of 2008. We expect consumer spending growth to weaken to a 1.5% annualized pace during the first three months of the year.

The softer first-quarter 2008 momentum implied by the weaker-than-expected retail sales data will likely keep the Fed aggressive with their policy actions in order to mitigate the downside risks to growth. We are expecting that the Fed will opt for 50 basis points of cuts at their January 29-30 policy meeting.

Modest decline in U.S. producer prices; core prices rise
Paul Ferley, Assistant Chief Economist

The December producer price index fell 0.1%, a substantial slowing from the 3.2% monthly increase in November. The earlier strong increases are keeping the year-over-year rate high at 6.3%, although this is down from the 7.2% recorded in the previous month. On a core, or ex food and energy, basis, December prices were up 0.2% and 2.0% during the past year. The monthly increase was down from 0.4% in November, although the year-over-year rate was unchanged from the previous month.

The moderation in the overall monthly increase was largely a reflection of the 1.9% fall in energy prices in December after surging 14.1% in November. The moderation was tempered by a 1.3% rise in food prices after recording no change in the previous month. Upward pressure was evident in a number of food components, including fresh vegetables, beef and veal, and processed fruit and vegetables.

The moderation in core prices largely reflected a 0.9% drop in passenger cars after a 0.6% jump in November. Car companies are likely cutting prices to help move out the remnants of the old car lines as the 2008 models are rolled into the showrooms.

Today’s report indicates that earlier energy price increases are keeping the annual increase in producer prices high at 6.3%. The year-over-year increase in core prices is rising a much more moderate 2%, although this is likely at the upper end of what is deemed as acceptable by the Fed. As well, Fed Chairman Bernanke has gone to great lengths to emphasize that the Fed had not taken its eye off the risk of higher energy prices putting even greater upward pressure on the core measure. However, despite these risks, the near-term focus of the central bank is to ensure that the economic expansion continues in the face of the ongoing financial market volatility and attendant credit tightening. Thus, today’s report does not alter our view that Fed funds will be lowered a further 100 basis points during the first half of this year, with the first installment, a 50-basis point cut, coming at the conclusion of the next FOMC meeting in January 29-30.

U.S. grains explode, raise inflation fears

By K.T. Arasu

CHICAGO, Jan 11 (Reuters) - U.S. grains exploded on Friday, with bullish government data helping corn, soybeans and wheat soar and build on their impressive gains in 2007 while raising concerns over food price inflation that has been edging up.

The catalyst for the rally was a slew of reports from the U.S. Agriculture Department on crop production and stocks in the United States and across the globe -- keenly awaited data that had a few surprises in store for traders.

"What a report today," Rich Feltes, senior vice president of MF Global said. "Corn stocks tops the list of surprises. Corn could quite easily be limit-up today," he said on a CME Group-hosted panel discussion of the reports more than an hour before the Chicago Board of Trade opened for business.

Corn futures did open 20 cents per bushel higher, the most the market can move either way on a day, and ended that way.

Soybeans and wheat futures also rose by the daily trading limit of 50 cents and 30 cents a bushel, respectively.

"It's like a perfect storm," said analyst Dax Wedemeyer of U.S. Commodities, based in West Des Moines, Iowa.

He said high prices for corn, however, along with those for wheat and soybeans, could translate into further increases in the price of food products for consumers.

"For the buyer, obviously there will be economic concerns because before too long this will cause higher prices for food. We are already seeing this happen," he added.

MF Global's Feltes said the USDA needs to "choke off ethanol usage in the country," adding that the high price of corn, fueled in part by demand from the renewable fuel sector, was hurting livestock operations that depend on corn for feedstock.

He said the livestock sector was going "deeper into the red" because of the high cost of corn, which gained 14 percent in value last year and hit 11-year highs this year.

The U.S. Agriculture Department on Friday forecast U.S. surplus corn stockpiles at 1.438 billion bushels at the end of the 2007/08 marketing year on Aug. 31.

The tally is down from the USDA's December estimate of 1.797 billion and compared with trade estimates for 1.709 billion. The USDA pegged soybean ending stocks at 175 million bushels, down from December's 185 million and compared with trade estimates for 172 million.

The USDA forecast wheat ending stocks in the 2007/08 season that ends May 31 at 292 million bushels, up from its December estimate of 280 million bushels and compared with 271 million estimated by traders and analysts.

The USDA reported 2008 U.S. winter wheat seedings at 46.610 million acres, up 4 percent from 2007, but below the average trade estimate of 48.6 million.

Feltes said grain and oilseed markets are going to be very sensitive to developments in crop weather in South America, where Brazil and Argentina are key producers of soybeans, corn and wheat.

He said CBOT futures posted gains in Asian trading hours on Friday "just on a turn in the Argentine weather to a drier tone."

Dan Basse, president of research firm AgResource Company, told the panel that the reports would put pressure on the USDA to move land out of the Conservation Reserve Program, where farmers are paid to idle farm land for environmental reasons.

CBOT March corn rose the 20-cent limit to $4.95 a bushel, with the May crossing the $5 mark. March wheat rose 26-3/4 cents to $9.09-1/4 while May rose the 30-cent trading limit to $9.22-1/2.

March soybeans ended 42 cents higher at $12.86, while May ended 38-1/2 cents higher at $12.98-3/4 after rising the 50-cent limit. (Reporting by K.T. Arasu, editing by Matthew Lewis)

Central Banking

The video is an interesting history lesson with some controversial conclusions.

And here in Canada - - - all is (not) well.

OTTAWA (Reuters) - The Bank of Canada may have overstepped its legal powers during the summer credit crunch and legislative changes are needed to clarify its role in future financial market crises, an independent report said on Tuesday.

From August 15 to September 7, the central bank temporarily expanded its list of collateral used when conducting open-market operations to boost liquidity and reinforce its target for the overnight interest rate.

The bank stepped into "questionable legal territory" when it began accepting commercial paper, foreign bonds and corporate bonds in addition to the usual government securities, bills of exchange and promissory notes, argued John-Paul Koning of the C.D. Howe Institute, a think tank.

"The bank's actions may have exceeded its statutory authority and, if Parliament believes it necessary that the bank should have the scope to act as it did, legislative changes are needed," Koning wrote.

The law governing the Bank of Canada says that only government-issued and guaranteed securities may be used as collateral for central bank operations designed to influence the overnight lending rate. These include the Special Purchase and Resale Agreements, whereby it buys securities with the agreement to sell them back the next business day.

The list of collateral is less restrictive for lending through the Bank of Canada's Standard Liquidity Facility. It was this list that the bank adopted temporarily for its purchase and sale operations in the market.

The law gives the central bank extended buying and selling powers in times of financial emergency but only if the governor publicly states that an emergency exists, something Bank of Canada Governor David Dodge did not do in August.

Lawmakers should decide whether they want to give the Bank of Canada the power to use private sector debt as collateral when ensuring short-term financing in times of financial market difficulty, Koning said.

"The Bank of Canada should offer Canadians a comment on its actions of this past August. Policymakers should also revisit the thinking behind certain sections of the Bank of Canada Act," he said.

"Failure to do so could hamper the bank's response the next time the financial system runs into trouble."

Dodge signaled on October 21 that he was mulling possible changes to the bank's liquidity provisions. In a speech in Washington, he floated the idea of a new central bank facility that would provide liquidity to banks at terms longer than overnight, collateralized with a possibly wider range of securities.

Deputy Governor Pierre Duguay repeated the idea in a November 20 speech. "The types of market failure that such a facility would be designed to deal with would obviously need to be very carefully considered to avoid weakening the incentive for preventive risk and liquidity management by market participants," he said.

Dodge and Senior Deputy Governor Paul Jenkins will be answering questions from the Senate Banking Committee on Thursday and the incoming governor, Mark Carney, appears before the House of Commons finance committee on Wednesday afternoon.

(Reporting by Louise Egan; Editing by Peter Galloway)

Value of Gold and Dow Jones in Canadian Dollars

With the rapid rise in the Canadian dollar I was curious to see how it has affected US demoninated investments.

First up is the Streetracks Gold ETF which is the equivalent to 1/10th an ounce of gold. Gold is quoted in US dollars so it can be difficult for us Canadians to grasp how that affects us when our currency is so volatile against the US dollar. Gold was $443 US in late 2004 and $535 CDN. At the beginning of 2007, gold was $622 US and $725 CDN. Now gold is at $822 US and $754 CDN. Dramatic appreciation in US dollars and very modest appreciation in Canadian dollars.



The Dow Jones Industrial Average (DJIA) was 10572 US in late 2004 and 12765 CDN. It was 12474 US at the beginning of 2007 and 14531 Canadian. Now the DJIA is at 13266 US and 12165 Canadian. Over the 3 year period the DJIA appreciated over 25% in US dollars but is down nearly 5% in Canadian dollar terms since 2004. Since the beginning of 2007 the Dow Jones has gone down nearly 20% in Canadian dollar terms while rising over 6% in US dollar terms. Wildly different results depending on the currency you are measuring in.


Cheers.

A Picture of Modern Hyperinflation - Zimbabwe

Zimbabwe (1999 - present)

NY Times Article

The Rhodesian dollar (R$), adopted in 1970, following decimalization and the replacement of the pound as the currency, was set at a rate of 2 Rhodesian dollars = 1 pound (R$ 0.71 = USD $1.00). At the time of independence in 1980, one Zimbabwean dollar (of 100 cents) was worth US$1.50.

Since then, rampant inflation and the collapse of the economy have severely devalued the currency, with many organizations using the US dollar instead.

On 16 February 2006, the governor of the Reserve Bank of Zimbabwe, Dr Gideon Gono, announced that the government had printed ZWD 21 trillion in order to buy foreign currency to pay off IMF arrears.

In early May 2006, Zimbabwe's government began rolling the printing presses (once again) to produce about 60 trillion Zimbabwean dollars. The additional currency was required to finance the recent 300% increase in salaries for soldiers and policemen and 200% for other civil servants.

In August 2006, the Zimbabwean government issued new currency and asked citizens to turn in old notes; the new currency (issued by the central bank of Zimbabwe) had three zeroes slashed from it.

In February 2007, the central bank of Zimbabwe declared inflation "illegal" and outlawed any raise in prices on certain commodities between March 1 and June 30, 2007. Officials have arrested executives of some Zimbabwean companies for increasing prices on their products.

How Do You Play the Inflation Game?

Check this article out for a case of why inflation will be a severe problem in the next few years. If inflation is going to be a problem in the next few years, what should one invest in?

1) Broadly speaking, stocks and real estate beat inflation over the long run. That said, adding undue risk by paying too much for stocks or real estate is not smart either and current market valuations are on the high end of the scale historically speaking. However, value stock picks can be found even in today's market (real estate is a different story altogether - I challenge anyone to find me a 'value' real estate pick - P/E <10). Passive investors could consider investing in a Value Exchange Traded Fund like the iShares XCV, IWW, or EFV depending on the market you want to invest in. Value mutual funds like ones managed by Cundill, Brandes, Brandywine, Sionna, or Chou can be a good fit as well.

2) More specifically, one could hedge exposure to increasing prices on the necessities of life - food, water, shelter and health care for example - by investing in companies that profit during times of rising prices or in the commodities themselves. This can be done quite easily by using Exchange Traded Funds that focus on these areas. Some examples of these ETFs are:
Food - MOO - Agribusiness
Food - DBA - Agricultural Commodities
Water - PIO and PHO - Water technology and resources
Food and other- PSL - Consumer Staples
Food - PBJ - Food and Beverage
Medicine - PJP - Pharmaceuticals
Shelter - XRE - Canadian Real Estate Investment Trusts

3) Real Return Bonds offer a guaranteed principal repayment and a yield that adjusts with the Consumer Price Index which should match inflation. If you believe the bond market does not reflect the risk of inflation going forward than RRBs can be a good way to put your money where your mind is. There are also a few RRB mutual funds available from TD, Altamira, Dynamic and Mackenzie. There is also a RRB index fund available from iShares - XRB.

4) Historically speaking, gold and silver have been traditional hedges against inflation as well. One can purchase physical gold and silver via several coin and bullion dealers. One can also invest in gold and silver via ETFs GLD and SLV or in mining companies that profit when gold and silver prices rise. Many precious metals mutual funds and ETFs are also available.

Inflation - Different Schools of Thought

Inflation, as most people generally interpret it, is "a persistent rise in the general price level, as measured against a standard level of purchasing power." This is currently the way that inflation is measured in North America and subsequent attempts on controlling it are based on these measurements. In Canada, when referring to inflation, we reference CPI, or Consumer Price Inflation. The Bank of Canada attempts to keep CPI in a range of between 2% and 3% through controlling the overnight lending rate or "prime rate" and this policy meets with some success.

"Mainstream economists' views of the causes of inflation can be broadly divided into two camps: the "monetarists" who believe that monetary effects dominate all others in setting the rate of inflation, and the "Keynesians" who believe that the interaction of money, interest and output dominate over other effects. Keynesians also tend to add a capital goods (or asset) price inflation to the standard measure of consumption goods inflation. Other theories, such as those of the Austrian school of economics, believe that inflation is caused by an increase in the supply of money by central banking authorities."

The thought I wanted to put forward today is this: What if the current Keynesian view and approach is faulty? What if inflation is more accurately termed as the Austrian school view it as an increase in the supply of money by central banking authorities? If this is true, what would we observe?

To illustrate I've put together a chart comparing recent Consumer Price Inflation with the Bank of Canada M3 total Money Supply. The question I have is: Where does the money go once it is created? Consumer goods? Homes? Cars? Stocks? Equipment?

Bear Cave - Feel Free to Growl

Good morning,

There are lots of little things going on that are not worthy of their own post so here is a place we can discuss them all.

1. Interest rates went up today. As was widely expected, the Bank of Canada raised the short term rate to 4.5%. They also said that "some modest further increase in the overnight rate may be required to bring inflation back to the target over the medium term.”
2. There is a new blog on the block where we can find daily updates to the local real estate inventory situation - http://vannumbers.wordpress.com/. Welcome REsteven.
3. Canadian Housing Starts are still hot, hot, hot. In the words of Beata Caranci at TD Economics, "Canadians can sleep well under their roofs tonight with the belief that the housing experience on this side of the border looks to be day-and-night versus its U.S. counterpart."

Mortgage rates rise again

Update: Renewal Gap Chart

Higher mortgage rates across the board means that anyone renewing a mortgage right now is looking at a potentially sizeable increase in their interest rate.

Canadian Press
June 13, 2007 at 2:08 PM EDT
TORONTO — Residential mortgage rates are moving upward again as bond-market yields bounce around five-year highs.

The Royal Bank of Canada said Wednesday it is raising posted rates by between 0.05 and 0.20 percentage point, depending on the term. Effective Thursday, the five-year closed rate goes up 0.15 point to 7.44 per cent.

It's the fourth rise in less a month during a series of increases taking the five-year rate up by 0.85 point, from 6.59 per cent on May 17. The other chartered banks have in recent weeks followed the lead of RBC.

The upward trend reflects a slump in prices and rise in yields in the international bond market where banks get their funds for mortgage lending, as central banks in most major economies have either raised interest rates or indicated they expect to, in order to contain inflation.

Ron Paul on Money

Milton Friedman on Government

Money - is it what you think?

Free For All

It's a free-for-all kind of day today.

We could discuss:

Inflation - it's up
Federal Budget - spending is up, taxes are down (kinda)
Housing - it's silly - inventory is rising, sales are declining
Markets - ambivalent

You lead the way.