Some Thoughts on Bank of Canada and House Prices

Deputy Governor of the Bank of Canada John Murray gave a speech to a crowd in New York on global rebalancing. I'm certainly not learned enough to comment meaningfully on his arguments and rationale but he did mention something in subsequent commentary about Canadian housing:

Canada's heated housing market appears to be cooling as desired, a senior Bank of Canada official said on Tuesday, although he noted that housing starts remain unusually high.

Housing prices and construction in Canada roared higher in 2011 amid low interest rates, sparking fears of a U.S.-style bubble. The market started to slow after the government tightened rules on mortgage lending in July, and policy makers hope to see a gradual softening rather than a crash.

"It's still early days. But we're certainly seeing evidence of movement and acceleration in the right direction," Murray told a business audience after giving a speech in New York.

"Some sort of smooth transition, at least on the housing side, is what we're looking for," he said.

An interesting comment for a "housing analysis" blogger! Murray is commenting that transitioning housing to a more sustainable level is something the Bank is looking for, and on which is likely advising the government to form fiscal policy. So we can play some guessing games as to what the Bank of Canada would like to see for a "smooth transition" and what that means.

What are the risks of high house prices and debts? Currently there is some risk of external economic shock to incomes, but absent that, with real rates depressed, debt-service ratios are currently for the most part manageable. If rates increase, however, this poses a significant headwind for the Canadian economy and worse could be almost impossible for policymakers to contain the fallout. Luckily, based on the yield curve, it looks as if rates have a good chance of staying low for a prolonged period, perhaps for the rest of the decade. The question then is what does Canada need to do in the coming years to ensure that when interest rates do rise she will not be caught out with excessive debt levels and overinflated asset prices.

Based on Murray's comments we have a smidgen of a clue what the Bank's and government's strategy is on the front of asset price reversion. It looks as if they are trying to pull of a "smooth transition" of prices back to levels that are able to be carried with historical interest rates. If prices continue at current levels (or increase) they will not have reverted quickly enough to stave off a big shock when rates rise. If prices fall too quickly this will lead to situations where a large swathe of owners are in negative equity situations, something that has knock-on effects to the broader economy. Given the assumption the Bank wants to control the band in which prices revert, we can do a quick calculation what that would mean for prices.

Say prices as a ratio to incomes are 40% above their long-term average. To revert prices to this range will require a 30% drop. To do this in seven years requires a -5% annual drop in the price-income ratio. Assuming incomes rise by 2% per year that means national prices need to drop at -3% per year for seven years to revert. If markets like Vancouver are, say, 50% overvalued, that will require prices dropping at -5% per year with 2% annual income gains to revert.

Prices do not often move in a straight line, rather we should expect that price drops will be more severe near the middle of the reversion and less severe near the ends. We can approximate this trajectory as a raised-cosine profile, say

P=(Pi-Pf)/2*cos(π*x/L) + (Pi+Pf)/2

where P is the price, Pi is the initial price, Pf is the final price, x is the year from start of correction, and L is the duration of the reversion target. Below are the year-on-year price change results for a 20% and 30% decline in prices:

Assuming the Bank of Canada is serious about price targeting we have some rough estimates of the level of annualized price drops required to pull off this delicate manoeuvre. As a reference, Vancouver looks to be on track for between -4% and -6% annualized price drops in the late winter of 2013.

But here's the thing -- if prices are to revert in a controlled manner, as regular readers of this blog know, this necessarily requires a certain ratio of for-sale inventory to prices. In other words, to ensure prices drop at a defined rate it will likely mean the government will need to control the level of sales. The only ways I can see them accomplishing such a feat are through controlling immigration intake -- not easy since they don't have much control on where immigrants settle -- and through credit availability.

In short, if the Bank of Canada is indeed "price targeting" so as to attempt to revert housing valuations to their long-term averages in the advent of future interest rate hikes, I believe we can expect further adjustments to controls of credit availability, both looser and tighter, over the coming years. It will remain to be seen how much capacity is left to accumulate additional credit, and where it can be stuffed!

October 2012 CMHC Data - Vancouver CMA

Here is the chart for housing starts, completions, and under construction for Vancouver Census Metropolitan Area (CMA) to October 2012:

Below we can see a continued high level of multi-unit construction compared to detached construction. The long-term trend for detached construction is down.

The last three years have seen an increasing amount of starts and under construction volume. Completions are trending upwards, as expected -- completions typically lag starts, so if starts are trending higher that will likely mean completions will trend higher as well. 12 months of completions are now 30% above the trough in 2011. (The actual trough was in early 2011.) With this increased level of completions, and what looks like either a plateaued or further-increasing level of completions into next year, we can expect increased competition among sellers in 2013. 

This is some analysis we can use to help formulate some predictions for the Vancouver housing market in 2013.

Predicting Prices in Vancouver

Below is an overview of an analytical method used to predict Vancouver prices. I have been predicting price changes on a short-term basis (looking out a few months) and this is not done through pie-in-the-sky guesswork, this is based on a defined set of steps and calculations.

Housing-analysis blog creater and owner, and financial planner, "mohican" noticed back in 2007 there was a (negative) correlation between so-called "months of inventory" (MOI), the ratio of reported for-sale inventory to monthly sales, to price changes. MOI tells us how long it will take to clear inventory at current sales rates. Other equivalent measures you may hear are months of supply, sell-list ratio (the inverse of MOI), and months to clear. This blog refers to MOI, and data can be found on REBGV news releases. (Note that Fraser Valley real estate board also published similar stats, and the correlation is good there as well; this analysis is only for REBGV data.)

Price changes are measured using the Teranet HPI, however similar correlations to MOI exist with the MLS-HPI and to a lesser extent median price changes. In order to account for month-month sales noise MOI is averaged over three months. I only have complete monthly inventory data for REBGV to 2005. There are likely data before this but I do not have access to them.

Two further innovations come by first recognizing that correlation changes depending upon the period over which price changes are measured. For example the correlation to quarter-on-quarter price changes is better than month-on-month price changes. Second the correlation becomes better if we time-shift the data (i.e. cross-correlate).

Below is a graph of the cross-correlations between price changes over different intervals and 3-month-moving-average MOI:

What this shows is that the highest correlation exists when correlating half-on-half price changes with a 3 month delay. The scatterplot showing this relationship is below:

Note MOI is displayed on as logarithmic scale. Other correlations are not as good but still not bad. Looking at year-on-year and quarter-on-quarter, both appropriately time-shifted, show the relationship is not as high but still obvious:

The most recent price weakness is shown on the QOQ graph above, indeed 2012 is behaving as previous years.

An important, and powerful, note on these graphs is that because of the time-shifted peak correlation, only MOI numbers from the past are displayed. For example the HOH graph only displays MOI to 3 months ago, the YOY graph only displays MOI to 6 months ago, and the QOQ graph only displays MOI to last month. That means that if we know MOI today (and we do thanks to Realtor Paul Boenisch posting daily sales, listings, and inventory on vancouvercondo.info)  we can use this model to predict prices some months out.

Take the HOH graph above and apply current 3 month average MOI (about 10) to the graph. That implies that we should be seeing a -5% half-on-half change in the Teranet HPI 3 months from now, in January 2013. A weaker measure is to use the YOY graph and forecast prices 6 months from now; based on that measure we should see the Teranet HPI down -4% to -6% year-on-year in April 2013.

In summary a method of forecasting Teranet HPI for Vancouver has been presented. By finding peak negative cross-correlation between months of inventory and price changes over defined periods it is possible to calculate predictions with varying degrees of strength. Further work expanding this method into other cities is possible.

Teranet - November 2012

NOVEMBER 2012

OCTOBER HOME PRICES UP 3.4% FROM A YEAR EARLIER The Teranet-National Bank National Composite House Price Index™ for October was up 3.4% from a year earlier, for an 11th consecutive month of deceleration in 12-month inflation. Up through September this cross-country trend was replicated in the Vancouver market, but in October this was no longer the case. In Montreal 12-month inflation has decelerated in 10 of the last 11 months, in Toronto in each of the last six months, in Winnipeg in each of the last four months. Twelve-month price changes continue to vary widely. In October the 12-month gain exceeded the national average by a wide margin in four metropolitan areas: Halifax (8.9%), Hamilton (7.2%), Toronto (6.4%) and Winnipeg (5.9%). In Montreal (3.6%) and Calgary (3.5%), it was close to the national average. In Quebec City and Edmonton the 12-month rise was 2.6% and in Ottawa-Gatineau it was 2.5%. Prices were down from a year earlier in Vancouver (−1.0%) and Victoria (−1.7%). Teranet – National Bank National Composite House Price Index™ Contact Us For general enquiries: info@housepriceindex.ca For licenses covering all index-linked products, please contact: Simon Côté  514 879-5379 Website www.housepriceindex.ca

The composite index was down 0.2% from September. It was the third October monthly decline in 13 years of data, including 2008 when the country was on the verge of recession. Prices were down from the month before in seven of the 11 metropolitan markets surveyed. For Quebec City (−0.9%) and Victoria (−0.6%) it was a third straight monthly decline. Toronto was also down 0.6% on the month. For Ottawa-Gatineau (−0.4%) and Montreal (−0.3%) it was a second consecutive monthly drop. Prices were also down in Calgary (−0.2%) and Halifax (−0.1%) and flat in Winnipeg, even if the resale markets in these three regions are considered tight. Prices were up 0.1% in Vancouver, 0.3% in Edmonton and 0.4% in Hamilton. Teranet – National Bank House Price Index™ The historical data of the Teranet – National Bank House Price Index™ is available at www.housepriceindex.ca. Metropolitan area Index level October % change m/m % change y/y Calgary 161.90 -0.2 % 3.5 % Edmonton 167.81 0.3 % 2.6 % Halifax 142.26 -0.1 % 8.9 % Hamilton 140.18 0.4 % 7.2 % Montreal 149.07 -0.3 % 3.6 % Ottawa 141.41 -0.4 % 2.5 % Quebec 170.25 -0.9 % 2.6 % Toronto 147.72 -0.6 % 6.4 % Vancouver 168.46 0.1 % -1.0 % Victoria 139.49 -0.6 % -1.7 % Winnipeg 189.94 0.0 % 5.9 % National Composite 6 153.66 -0.3 % 3.5 % National Composite 11 154.59 -0.2 % 3.4 % The Teranet–National Bank House Price Index™ is estimated by tracking observed or registered home prices over time using data collected from public land registries. All dwellings that have been sold at least twice are considered in the calculation of the index. This is known as the repeat sales method; a complete description of the method is given at www.housepriceindex.ca The Teranet–National Bank House Price Index™ is an independently developed representation of average home price changes in six metropolitan areas: Ottawa, Toronto, Calgary, Vancouver, Montreal and Halifax. The national composite index is the weighted average of the six metropolitan areas. The weights are based on aggregate value of dwellings as retrieved from the 2006 Statistics Canada Census. According to that census1, the aggregate value of occupied dwellings in the metropolitan areas covered by the indices was $1.168 trillion, or 53% of the Canadian aggregate value of $2.207 trillion. All indices have a base value of 100 in June 2005. For example, an index value of 130 means that home prices have increased 30% since June 2005. By: Marc Pinsonneault Senior Economist Economy & Strategy Group National Bank of Canada Teranet - National Bank House Price Index™ thanks the author for their special collaboration on this report. 1 Value of Dwelling for the Owner-occupied Non-farm, Non-reserve Private Dwellings of Canada.

Greater Vancouver Market Snapshot October 2012

Below are updated sales, inventory and months of inventory graphs for Greater Vancouver to October 2012. (see REBGV news releases.)

The scatterplot of price changes and months of inventory is below. As the Teranet data roll in, look for more points appearing the right-hand side.

Commentary:

October continued with relative weakness compared to not only 2011 but also past years from 2005 (except the residual emerging from the recession of 2008-2009). October sales are near lows in at least the past decade, though close to levels seen in 2008.

Due to weekend framing effects the rebound on the sales graph above is overstated. To partially compensate for this I have plotted sales per working day on a month-by-month basis. Using this more accurate gauge we can see that relative strength in October is muted:

This October was another weak report. Sales year-to-date are bad and this has direct effects on incomes of those who depend on resale turnover for income. I would not be surprised to see prices down between -6% and -4% year-on-year by February or March of 2013.

As a recurring reminder, there are some worrying clouds on the horizon: population growth is falling, dwelling completions are set to increase over the next year if not longer, and banks have implemented stricter mortgage guidelines in the form of changes to government-underwritten mortgage insurance qualification criteria and second, completely as of November 1st, via implementation of stricter mortgage lending guidelines under OSFI's new directives. (Credit Unions are one notable exception.) Further stress in current conditions can be attributed to China's slowing economic growth.

On the other hand mortgage rates remain low, near net zero real territory, and it is possible for rates to remain low for a prolonged period (i.e. years). It looks likely that Asian economies are due for another round of investment spending through coordinated government stimulus measures -- not only in Asia but also in other jurisdictions -- and that can plausibly lead to a renewed, but in my view temporary, bout of current account flows into Vancouver-area property investments.

While October sales per day were about 9.6% higher than September's, some perspective is required: sales levels are still well below the average of the past decade. All else equal I expect November sales to track October's level, perhaps slightly weaker but not markedly so. I estimate total sales for November to come in at about 1700.

Yet another weak report for resale housing activity in the Vancouver area.

BC Employment by Sector October 2012

Below are some graphs highlighting BC's employment over the past 15 years in various sectors. But first here are the historical employment, participation, and unemployment rates (CANSIM tables 282-0117 and 282-0087)

And the spreads between the rest of BC and Vancouver CMA.

Here are the contributions of the two major goods producing sectors (construction and manufacturing) as a percentage of total employment. These are seasonally unadjusted with 3 month moving average applied (CANSIM table 282-0111).

And the service producing sectors (NSA)

The red line on the service sector graph, "Finance, insurance, real estate and leasing [52-53]", has dropped down as it did in 2008. Transportation and warehousing is showing a marked rebound as % employment. Strength in manufacturing has waned of late. This is not what I would consider a bullish survey -- unemployment remains stubbornly high compared to the government's targets, though perhaps these levels are not much of a surprise if one looks at how the low levels of unemployment of the last decade were produced.