Monday, June 29, 2009

Giving credit where credit is due

Back in January, I asked whether Carney had lost it.

He had stated the following in his outlook:

magically, in July, the economy is going to grow 2.0% and immediately stabilize. Then, it will grow by 3.5% in Q4. Oh, and then it gets better: 4.7% in the first half of 2010 and 4.9% in the second half of 2010.
He recanted his view in April.

If he lost in January, he may have found it. He has finally understood that what happened here is no garden variety recession. Listen to him:

From Bloomberg:

Bank of Canada Governor Mark Carney said Canadian households are facing rising “stresses” that could lead to losses for banks, while repeating concern about the effect of a strengthening currency on the economy.

“Sharp increases in unemployment are raising the incidence of financial stress among households,” said Carney, 44, in the prepared text of a speech he gave today in Regina, Saskatchewan. An unemployment rate exceeding 10 percent “would lead to significant increases in losses for financial institutions,” he said.

From the Globe:

In recent speeches in Montreal and Regina, the bank governor was almost dismissive of indicators of economic improvement, warning that whatever good news existed was caused artificially by massive government and central bank stimulus. The private sector “is not there yet,” he cautioned.

And in a report from an off-the-record speech Tuesday at the Woodrow Wilson International Centre for Scholars in Washington, Mr. Carney broke with official Ottawa dogma in declaring Canada's recession to be as deep as that in the U.S.

All this is getting the Bank establishment angry. They are probably talking their books and probably don't appreciate the comment about "significant increase in losses for financial institutions".

“Nobody expects policy makers to be cheerleaders, but do they have to be naysayers?” asked Douglas Porter, deputy chief economist with the Bank of Montreal, who is among several who wonder at Mr. Carney's transformation from Mr. Sunshine to Dr. Gloom in four months.

I think Carney may have found it after a winter in fantasyland.

Some excellent news

One piece of excellent news is that the savings rate in the US hit 6.9% in May, the highest since 1994. The savings rate has now rebounded from under 1% in 2007 and early 2008. The May rate was artificially inflated by stimulus from President Obama, but nonetheless, the savings rate has been trending higher over the past year. The savings rate and incomes rose while consumer spending was basically flat.

In the 1970s, the savings rate ranged from 8-12%. Credit cards were in their infancy and mortgages were relatively small (due in part to high interest rates).

In the 1980s, as interest rates dropped and the boomers were in their heydey, the savings rate dropped under 8%.

In the 1990s, as the stock market bubble developed, the savings rate dropped from 8% to 2%.

In the 2000s, the housing bubble finished off savings, which went to about 0%.

It is likely that the savings rate will drop a few percentage points once the stimulus wears off but I believe that we are heading to a permanent 10-15% savings rate over the next few years and it will last for the next decade at least. The faster we get there, the better in my humble opinion.

The fact that almost all of the stimulus was saved by US households tells us that there has been a sea change in attitude by US consumers. If they receive an extra dollar, they are saving it as opposed to spending it. That tells us two things:

1) When the Obama direct stimulus wears off later in 2009, consumer spending may fall further if it has been cushioned or improved even slightly by this stimulus.

2) It is hinting that as time goes on, the savings rate will continue to go up, given the sea change in attitude.

Now, all this flies in the face of the "green shooters" who feel that consumer spending will start to rise later in 2009. The only way that consumer spending, which is the lifeblood of the US economy, can recover is through job creation (nope), higher wages (nope) or less saving. The green shooters and all these Canadian bank economists who project a return to spending in the second half (as if this was all a bad dream) are dismissing this rise in savings as a temporary response to the stock and real estate market declines.

I am saying that this increase in savings is a long term phenomenon. In the short term, the rise from 0% to mid single digits is killing the retail and consumer based portions of the economy. The rise in the savings rate of almost 5% in one year is creating havoc in the economy. One man's savings is another man's income (the paradox of thrift popularized by Keynes).

Households are finally realizing that their stock, housing and pension assets were inflated and are rationally cutting unnecessary spending to build savings and reduce debt. The retirement age population is going to soar in the coming decade, due to the early baby boomers reaching 65 soon, and sadly, many have little savings. This realization is likely going to continue for years and possibly decades.

Savings need to be rebuilt for a sustainable and healthy economy and the good news is that the secular change in the private sector is well underway. Hopefully, governments will quit tampering so much with the extinguishing of debt. Governments are socializing the debt by running massive deficits and transfer private sector debt to the government (Fannie/Freddie, Citi, Bear Stearns, GM, TARP, mortgage security buyouts, etc...). I suspect that the public sector will also go through a sea change, forced by the bond market, in the coming years as well.

Thursday, June 18, 2009

Positive May housing report

A smart reader asked:

What I don't understand is with higher unemployment RE is not where it should be. I guess first time buyers have simulated the market with lower interest rates. It does not make any sense why average home prices are not declining.
I guess I don't fully understand it either.

First of all, let me admit, that I did not see this coming. If you had told me in the winter, that by May, CREA would report a positive YoY average sale price in Canada (and a record), I would have laughed hysterically. My forecasts for early 2009 were much too pessimistic as I underestimated the effect that super low mortgage rates would have on buyers.

Secondly, I am not going to revise my forecast for 2009 just yet, but I have to admit that it is looking too pessimistic. If you wish to dismiss this blog as overly bearish on housing, feel free. 

I usually hate it when people who are wrong, blame others for being wrong. At the risk of doing this, here goes: 

I did not think that a 50%ish drop in equity markets worldwide, a $115 drop in oil prices, a 30% drop in the Canadian dollar, a 30% drop in US home prices, a 2% increase in unemployment, a 10% drop in home prices in Canada in 2008, overprime, failing pension plans and a 7% drop in GDP in Q1 would rationally allow a "soaring" real estate market. Basically, the reasons that I outlined here prevailed over the factors that I mentioned above.

Either I am crazy (in being dead wrong in recent months) or that Canadians are crazy. (I think it is the latter). Now, I don't think the CREA numbers are that accurate (either in 2008 or currently) but they are what they are. 

I have many people telling me "it's a good time to buy". I suspect that this has to do with the super low mortgage rates that were around until a few weeks ago. As Canadians, I think that when we think of buying a house, the only thing that we think about it "What are my payments?". Have we not learned anything about leverage in the past two years? 

Few people are asking the following questions:

1) Why are mortgage rates super low? Ummm, maybe because we are in a severe recession or a depression.

2) What happens when my mortgage resets in 5 years if rates are higher? Your payments go up. This is what happened in the US with ARM resets.

3) What happens if I have to sell before the end of my mortgage (say in five years) because if me or my spouse loses a job? What happens to my mortgage in such a case if my house value drops by 20-30%? Ummm, it's called foreclosure. Look at US real estate sites with foreclosures. There are pages of them and the lists are increasing. 

4) What happens to my house value if there are foreclosures galore in my area and I want or need to sell?  Your house will sell for a lot less than you think.

5) What happens when all these baby boomers need to free up cash as for many their home is the principal source of retirement savings? Again, your house will sell for a lot less than you think.

6) What happens to house prices if we have a banking crisis in Canada? What happens to house prices if we return downpayments to 20 or 25%? Sound far fetched? We have an oligopolistic banking system in a country smaller than California. Anything is possible. In the US, downpayments of 25% are fairly common in 2009.  Either a banking crisis or 25% down will send house prices a lot, lot lower.

Obviously, any of these things could happen in even normal times. These are not normal times! If you can handle some of these situations and still make your payments, then go ahead. I suspect that most Canadians have not even considered these questions or if they have, they smugly dismiss this as a US subprime problem.

I don't think the spring silliness in Canadian housing is sustainable for very long and I think this does little to change the longer term picture for Canadian housing. Canadians are foolishly ignoring the lessons of past real estate market busts and the lessons of most Anglo-Saxon countries of the present. If I was trying to sell my house right now, I would be thankful for this potential last chance.

Mortgage rates are already creeping up and some of the pent-up demand (caused by the virtual collapse of housing in the fall of 2008/early 2009) has now been relieved. I am not going to venture a guess as to when this bear market rally in Canadian housing will end, but I know that it will roll over and when it rolls over the next time, it will be very, very ugly for a very, very long time. 

Tuesday, June 16, 2009

A brilliant article

I came across a brilliant article written recently in the Atlantic titled "The Quiet Coup" (thanks to Bill Cara's excellent blog). It covers the ties between the financial services industry and the US government and compares the US to other . The article is written by Simon Johnson, former chief economist of the IMF. I am not a fan of the dismal science, but Johnson is clearly brilliant.

I suggest reading it but I wanted to highlight two important passages:
It (a scenario) goes like this: the global economy continues to deteriorate, the banking system in east-central Europe collapses, and—because eastern Europe’s banks are mostly owned by western European banks—justifiable fears of government insolvency spread throughout the Continent. Creditors take further hits and confidence falls further. The Asian economies that export manufactured goods are devastated, and the commodity producers in Latin America and Africa are not much better off. A dramatic worsening of the global environment forces the U.S. economy, already staggering, down onto both knees. The baseline growth rates used in the administration’s current budget are increasingly seen as unrealistic, and the rosy “stress scenario” that the U.S. Treasury is currently using to evaluate banks’ balance sheets becomes a source of great embarrassment.

The conventional wisdom among the elite is still that the current slump “cannot be as bad as the Great Depression.” This view is wrong. What we face now could, in fact, be worse than the Great Depression—because the world is now so much more interconnected and because the banking sector is now so big. We face a synchronized downturn in almost all countries, a weakening of confidence among individuals and firms, and major problems for government finances. If our leadership wakes up to the potential consequences, we may yet see dramatic action on the banking system and a breaking of the old elite. Let us hope it is not then too late.
I agree with much of what Johnson has written, and I am planning to write an article soon on how I see this recession (depression) evolving over time. A hint: once again, almost everything in the mainstream consensus, especially in Canada, is completely out to lunch. Recent musings by CIBC economist Benjamin Tal had me both laughing and shuddering at the scope of the fantasy (I am planning a separate entry on this gem). 

The scenario that Johnson has outlined above is quite plausible and is consistent with portions of my scenarios that I am developing. The European banking system (as well as others) are in horrible shape and I expect things to get ugly over the next few months and years. One of the current fault lines is in Latvia, and I would keep an eye on developments there.

position in SKF, FAZ, SPY puts, BAC puts, Canadian bank shares, QID

Thursday, June 11, 2009

Government bonds are acting up

On May 12th, I mentioned that I believed that mortgage rates and interest rates were going up, so the conventional and normally sound wisdom about never locking in a 5 yr mortgage may not apply this time.

Back in March, I mentioned that I thought that interest rates were heading up.

Last week, mortgage rates went up 20 beeps (basis points) and this week another 40 beeps, 60 beeps total.  Sub 4% 5 yr mortgage rates in Canada are now gonzo... 10 year treasury bonds in the US are near 4%, up 2% from December. 30 year treasury bonds are inching closer to 5%. Mortgage rates in the US are up sharply as well.  And all this despite the Fed buying bonds (at record prices I may add).

This is one of the big stories of the first half of 2009: government interest rates are increasing. I am in the deflation camp. So how do I reconcile my deflation views with my view that the 30 year US treasury bond could go to 7% or 8%?

As Bob Hoye of Institutional Advisors has pointed out repeatedly, in a post-bubble contraction, real interest rates soar, despite falling inflation. Investor risk aversion spreads to long term government rates.

Look at the looming trillions of treasury bond issuances. Who is going to buy up all this debt?

I am not a fan of Keynes, but even he said that governments should run surpluses in good times and deficits in bad times. Instead most G7 (Canada excluded) ran reasonable deficits in great times and are now trying to run enormous deficits in very bad times. There was a "free lunch" for the last few months whereby governments issued trillions in debt to replace the drop off in the private sector demand and tax revenues. That free lunch is ending as the bond market is catching on.

Imagine the impact that soaring interest rates are going to cause on a debt laden economy? If this happens, I am changing the title of my blog from The Great Recession to something with the word Depression in it, because that is where we are heading if interest rates rise to the levels that I suspect that they might.

Corporate bonds have done nicely in recent months as the risk/reflation trade has returned, but the turn in the treasury market could be a warning of problems to come in both the corporate bond market and stock market. Last summer, disasters in the corporate bond market preceded the carnage in the equity markets in the fall of 2008. 

The US dollar may have bottomed last week, and that is also likely to lead to problems in the stock market. Last summer, the US dollar bottomed in mid July, roughly a month before the stock market peaked.

I should caution though, that in the short term, I think that the bond market is going to rally (I have no position in bonds right now) as the bond market is extremely oversold and should rise as corporate bonds, commodities and stocks fall in the coming weeks and months. I have initiated very small short positions (SKF, S&P puts) but I am waiting for further confirmation. I consider these signs to be an alert for trouble ahead.

Tuesday, June 2, 2009

Bank of Canada reversing course?

As recently discussed, the Bank of Canada has pledged to keep interest rates at 0.25% for about a year. I mentioned that they may be forced to raise rates if there was ever an attack on the loonie. This happened in 1992, I believe, and in 1998 during the Asian crisis.

Recently, the opposite has happened. The loonie is soaring and it hit 92 cents today. My portfolio is getting hit as my high cash position is mostly in USD (horrible timing to move to USD on my part), so take the following opinion as talking my book if you wish:

The recent move from 77 to 92, most of which has happened in the last month, has to be causing concern for the Bank of Canada.


1) We are in a deflationary period and a rising loonie is going to make things even worse, by making the inflation rate even more negative. Deflation makes real rates high (even with 0.25% nominal rates). This makes it difficult for interest rates to be stimulative.
2) The strong loonie is going to hurt our exports, which are already devastated by the recession. Certain commodities that are priced in US dollars will be just fine, but in places like Ontario, the manufacturing base (and GM?) can not be enjoying this recent rise in the loonie.
3) The timing of this currency appreciation is horrible, at a time when the window for the "green shoots" theory to work is open. Currency appreciation also works against the stimulus in the works.

Don't be surprised if the Bank of Canada, at its June 4th meeting, tries something to knock the loonie down.

At the last meeting in late April, the BoC annouced:

1) Interest rates were going to stay at 0.25% for over a year.
2) It would not be implementing quantitative easing (QE) for the time being.

Since then, 4 big things have happened:

1) The loonie has especially soared since BoC announced that there was nothing imminent on QE. Speculators used the annoucement and the loonie's position as a commodity currency to play the reflation trade.
2) Flaherty news of a bigger deficit last week (and the $10 billion of wasted money on GM yesterday) gives them cover (ie economy weaker than expected, deficits bigger than expected) to start QE.
3) Even the hawks at the ECB are trying QE.
4) Of late, interest rates are soaring. Left unchecked, it will kill the so-called recovery. QE will supposedly help.

Announcing immediate QE or that they are more inclined to do it (sooner rather than later) could take some of the recent gains out of the loonie and at least make it seem as if they are concerned about rising rates. They could also say that the recent rise in the loonie is not completely justified by economic fundamentals.

Don't get me wrong, I don't believe in QE and deep down, I am happy that the BoC said no in April. I also think that the loonie will ultimately trade based on market forces, regardless of what the BoC does. An announcement of QE though could trigger the inevitable correction in the loonie, however.

Is the Bank of Canada reversing course on QE? And perhaps later in 2009, will the market force it to reverse course on interest rates, thereby reversing both its announcements of the last meeting? 

Just asking...

Disclosure: Long USD cash and CAD cash. I think the loonie is topping here and heading lower in 2009, but I could remain wrong, and in the short run, anything is possible.

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