When is material, material?

The Bank of Canada kept its key benchmark unchanged.  The accompanying press release was read by the market to be slightly less dovish than expected.  

In their update, the Bank saw the global economy gaining traction, the US rebounding from its first quarter slumber and importantly said some positive things about the domestic economy.  They noted the firm labour market had lead to an improvement in consumer spending, that the adjustment to lower oil prices was now largely complete and that there had been some early indications of a return of business investment.  All good. 

At the same time, they noted that exports remained subdued and stressed again that their global and domestic outlook continues to be clouded by global uncertainties.  They also commented that the recently imposed measures aimed at the housing market have not yet had a substantial cooling effect.  As has been consistent with their glass half empty approach, they stated that second quarter growth would likely show some moderation from the very strong growth experienced in the first quarter.

Inflation was said to be broadly in line with their MPR outlook, with the headline number being temporarily pulled down by declining food prices.  As they did in April’s press release, they highlighted that the three amigos (measures of underlying inflation) remained well below their 2% target and that wage growth had been subdued.  In April they concluded that this was consistent with ongoing material excess capacity.  Now, although neither the core measures or wages has shown any new signs of life,  they claim that these two factors are consistent with ongoing excess capacity.  The word “material” was dropped. 

So was the word “material” dropped because the economy has performed better than expected thus leaving us with a smaller output gap than envisioned at this point, or was it dropped because the economy is tracking as expected and the dropping of the word recognizes that we are now six weeks closer to the closing of the gap in the first half of next year than we were in April.

Regardless of why the word was dropped,  with the output gap already expected to close early next year at the latest, and with the strongest economy in the G-7, one can easily justify an immediate move to start tightening policy and getting their overnight rate closer towards neutral.  However, the Bank appears to be in no hurry in getting that show on the road.  There is no panic, let alone any explicit thought of them risking getting behind the curve.   They claim that the current degree of monetary stimulus is appropriate, at present.  

It would seem that the Governor remains skeptical about the sustainability of the last few quarters’ reported growth (still too much household-debt based activity and not enough business investment and exports) and he continues to believe the dampening effects of the huge amount of uncertainty on the economy need to be offset by monetary stimulus.  

However, if the economy continues to chug along and even moderates from its current pace, as they suggest it will, the output gap will still be rapidly diminishing.  With each passing decision, they will risk getting further and further behind the curve.  If the Governor is waiting for the optimal point to start raising rates, time is not on his side.  The first move will have to happen before growth is declared to be sustainable, before there is clarity around all the uncertainties and well before the three amigos hit 2%. The risk is quickly becoming that the first move will come much sooner than he would like and before the markets expect.   

Bank of Canada: expect the same old thing

The Bank of Canada has another interest rate decision fast approaching.  I must admit, since the beginning of the year, it has been very entertaining to guess what rabbit they were going to pull out of their hat to justify maintaining their ridiculously accommodative policy.  With each passing decision, we are getting closer to when the output gap is expected to be closed.  When last we heard from them, this was envisioned in the first half of 2018.  Normally with the lags associated with monetary policy, market watchers could pencil in a central bank starting to slowly increase rates closer to neutral, well ahead of when the gap actually closes.  So, right around now.  

To date, the Bank has made it very clear that a rate increase is not in the cards.  Heck, they just took a possible rate cut off the table a few months ago.  They continue to stress that the economy has material room to grow with the size of the output gap remaining significant even with its closure only 3 quarters away.  Recent inflation readings only strengthens this view, particularly given the soggy performance of the three amigos (CPI-common, median, trim).  

The Bank had trained economists and the market to anticipate that the interest rate actions of a inflation targeting Bank would be ultimately determined by the amount of excess demand or supply there was in the economy.  If the output gap was expanding, there was excess supply, there would be downward pressure on prices and rates could be expected to go lower.  The opposite would be expected if there was excess demand and the output gap was closing.  The market could expect to see rates move higher.       

So, here we are with the output gap closing and expected to be gone in less than one year.  There is no indication that growth is slowing significantly below the Bank’s latest MPR outlook but there is also no indication that the narrowing of the output gap has, so far, exerted any upward pressure on core inflation or wages. This begs the question if a domestically focussed Phillips curve framework is still a useful guide for the market to use when trying to determine the timing of monetary policy in Canada under the current regime.  It still seems to be applicable in the US.  

It looks like this Governor will continue to ignore housing inflation and instead wait to see the whites of the three amigos’ eyes before he even thinks of pulling the trigger.  (This gives more time for the youth of our country to get a job and get out of their parents’ basements and it keeps downward pressure on the dollar.)  Despite what nominal growth may be suggesting about the closure of the output gap and what that would normally mean for monetary policy, until core inflation shows some life, the stretched dovish narrative linked to uncertainties and to doubts about the sustainability of growth will continue to dominate their press releases.

Home Capital, Regulators and the Big 6

In the previous blog,  I tried to point out the role the regulators may have played in creating havoc for Home Capital.  This made me think of the changes that the same regulators have imposed on the big 6 banks since 2008 and whether their stock prices should respond to this type of event in the same manner as they would have before the regulatory changes had been made or are they now more immune? 

The large banks do not have any significant direct counter-party exposure to HCG, one or two of them may lose a client to whom they can dump their “turn-down” mortgages but overall they will not even see a ripple if the firm folds.  The risk for the Big 6 is their significant exposure to the Canadian economy and the $1.4 trillion mortgage market that could be impacted by a housing correction possibly instigated by events like what is occurring at HCG.   Moody’s is getting more concerned.  They just announced a downgrade of the banks’ ratings citing their worries with deteriorating asset quality and weaker household balance sheets.  So how worried should people be about the large banks, especially now that the regulators have tightened things up?  

It depends on what your business is with them.  The big 6 would enter into any housing correction in a strong position.  The banking industry’s oligopoly structure,  its large holdings of only insured mortgages, its meeting of higher regulatory standards, stricter underwriting, and its ongoing robust risk management, theoretically suggest that they can survive an intense shock.  

So, if you are a retail depositor at the Big 6, no problem.  (Ultimately your only exposure is to CDIC and whether they know what they are doing—not zero risk.)  If you are a borrower, the risk is slightly higher, as the banks become more reluctant lenders, responding to their increased need for liquidity and to any deterioration in credit quality as a result of the shock.  

But it gets more interesting and uncertain if you are a holder of common equity.  In trying to ensure that the tax payer will never again be involved in bank “bail-outs”, the regulators have moved to increase the capital buffer that will absorb any losses before Mom and Pop are on the hook.   This has resulted in significantly higher potential losses to holders of various tiers of capital and, at some point in the future, to holders of wholesale bank debt.  Now, certain debt-like instruments that count as capital will have the potential to be converted into common equity either through various triggers linked to the market price of the stock or by the regulator’s magic wand.  Thus between these debt-like instruments outstanding and its common equity,  the regulators have determined that there is a higher probability that any loss can be absorbed by a bank in a time of crisis.  Thus if you hold these new wholesale debt-like structures or common equity, you are now carrying more of the risk if there is a threat to a bank’s solvency.  In finance jargon, the probability of a bank reaching insolvency is less given the increased liquidity and starting amount of capital, but if insolvency occurs, the estimated loss to the holders of common equity has increased as a result of the taxpayer not contributing to reduce any of the loss.  

Moreover, the regulators have been working on adding a bail-in feature to wholesale debt that the banks issue.  Again, in a crisis, certain triggers will allow this debt to be converted to common equity, further increasing the loss absorbency of the bank.  

This raises a couple of questions.  First, has the stock prices of the big 6 adequately discounted the potential amount of dilution that could occur from the conversion into equity from these other forms of capital and debt in a crisis? and second, supposedly with no taxpayer support coming, should stock prices now be more sensitive to the risk of contagion than they were prior to the regulatory changes?  

My guess is that bank equity prices are not discounting the current regulatory regime adequately but continue to be priced assuming that the taxpayer will be forced into the mix when the rubber hits the road.  Whether this is a good bet or not depends on the political will to do nothing, stay out and watch a major Canadian institution dissolve in an orderly manner.  

In 2008, the Canadian banks were the victims of a drive-by-shooting.   The crisis did not even start in this country, but that did not matter.  Liquidity froze and their stock prices collapsed.  To the market, it didn’t matter that Canadian banks had more capital, more liquidity and stricter guidelines than other jurisdictions.  In a crisis, with fear as a motivator, perception trumps reality.  The same will happen in the next crisis despite the regulators best efforts.  The market and the depositors will not care that the regulators have forced banks to hold even more liquidity and more capital.  As has always been the case, the next crisis starts when investors and depositors, for whatever unforeseen reason, want their money back—now—on demand.

Which takes us back to the bank stocks and whether they are now safer to hold post all these changes.  The new regulations have not reduced the chances of another bank run in the future.  They may have lowered the probability of a bank becoming insolvent, but not by as much as the regulatory gang in Basel would want us to believe and, without question, have increased the estimated size of a loss to a holder of common equity if a bank does become insolvent.  As a holder of bank equity, do you feel safer?  

Home Capital: Don't thank the regulator

Home Capital Group has recently dominated the conversation in capital markets.  Although the Minister of Finance has proclaimed that HCG’s difficulties will not be the catalyst of a housing correction,  no one can really predict what will be the actual fall out.   Everyone remotely involved are telling us that they are being extra vigilant, whatever that means.  In reality, I wonder if many are more sanguine in private about contagion, possessing a false confidence premised on the regulatory changes that have been made following the 2008 crisis in the US.  You know, the same crisis that showed us that financial instability could spread from one of the most regulated industries in the economy, the large banks.  This same crisis revealed that the competence of the regulator and implementation and enforcement of the existing regulations was more important than what was written.  In this context, what we see in Canada so far should scare us.  

The regulators would be the first to tell you that things are different this time.  This is not 2008, the entities that are on their watch have more capital, they have more liquidity and are held to higher standards when it comes to compliance.  They are right.  Things are different but I am not sure that guarantees that things will be better.  Actions taken by regulators globally have made each individual bank safer, but at the cost of making the system weaker.  The new rules have created an environment where it will be extremely challenging for a distressed bank to find a private sector buyer for their liquid securities if they are in need of funding.  The same new rules make it more costly to accept new deposits coming from a failing institution and the precedence set with the forced merger between Bear Sterns and J P Morgan will scare any sane financial institution away from voluntarily stepping forward to take over a failing firm regardless of where they are located geographically.  If a housing correction causes a US- like crisis of liquidity, regulators have assured us that it will not look like it did in 2008, and who is going to argue.  My fear is that it may actually be worse, with more non-bank victims caught by the banking system hoarding liquidity in response to the newly minted regulation.

Currently, despite all the changes to the rules, here we are again witnessing a bank about to become road kill, all the while meeting the stricter requirements set out by the new regime and while being scrutinized more intensely by the regulators.  The regulators deserve kudos for sniffing out the fraudulent mortgage activity at the firm, but they also should collect an award for pulling defeat out of the jaws of victory.  They somehow managed to fumble the ball and ended up as an accessory to seeing about $1.0 billion in deposits vanish.  Did the crime deserve this punishment?  They aided and abetted the demise of HCG and are now watching a solid, well capitalized bank dissolve in front of them.

How did they aid and abet this crime?  Some analysts say that the regulators mishandled the public disclosure that the firm had mislead investors by not acknowledging the fraudulent mortgages.  The regulators could have stressed that this action was done well in the past, it was dealt with and would not happen again under their watch.  This message did not get across. 

 The regulators may have also underestimated the sensitivities of depositors and market participants to any suggestions of wrong doings in the Alt-A mortgage market given still fresh memories of 2008.  

Additionally, if you assume that there had been ongoing dialogue between HCG and the regulators as to how their plight was unfolding, what did the regulators say or do as they watched HOOPP securely fasten the cement boots on HCG with the $2.0 billion line of credit at an effective rate of 22.5%?  I understand that the regulators would prefer a private sector solution, but did our ace regulators give any thought that by having HCG sign on the dotted line of a deal that reeked of desperation that it might scare the pooh out of the remaining depositors?   

The regulators tell us that HCG is not systemically important.  I hope they are right.  It is still very sad however if we see it upside down in the aquarium or even worse find out later that it played a part in ultimately starting a correction in the housing market.  If and when that day ever comes, there will be plenty of finger pointing, but it might have been the ones who are suppose to keep the system safe that actually shoulder some of the blame. 

Stay Short Canada

It has been a relatively good run for those long US dollars against Canada over the last few weeks.  Since mid-April that trade is up almost 3%.  But it seems like it should have paid out even more.  This last week alone our buck took some pretty stiff body blows from all sides.  

Hitting below the belt, Trump sacrificed Canada in order to score some political points with his constituents ahead of his first 100 days in office.  His voters can now be rest assured that their boy is serious about America coming first following the imposition of tariffs on softwood lumber, threats to tear up Nafta, and rumblings from his toadies about Canada’s unfair subsidies on everything from dairy to aircraft.  This pressure is not likely to end until negotiations begin.  

Adding to the gloom, our dollar is getting no support from energy nor does it appear that soggy oil prices are going to rebound any time soon.  

The domestic financial news was not friendly to the loony either.  Those who have been shorting the Canadian housing market for years, suddenly had something to chew on.  Home Capital Group, a small firm focused on providing mortgages to lower credits, ran into trouble with the regulators.  The basis of the regulator’s concern was with respect to making false claims, not the credit worthiness of the mortgages they are exposed to but the action did spur a sharp increase in deposits being pulled.  To try and get ahead of any liquidity problems, Home Capital set up a $2.0 billion line of credit with a large domestic pension fund.  The fund, God bless them, agreed to provide the first $1 billion at an effective rate of over 22%.  For HCG, the lifeguard just threw them a life preserver that weighs two tons.

As we all have learned from 2008, system liquidity is all about confidence and perception and is based less on audited financial statements.  Although the likelihood of contagion to the broader markets from the troubles at HCG is extremely low, the rapid increase in credit spreads at other firms in the same business tells us that the contagion risk is not zero. 

Finally, the release of GDP for February was not horrible for the currency, but it does give one pause, coming in flat for the month.   The breakdown underscored how dependent the economy is becoming on housing to generate any of the growth we are seeing.  Real estate, rentals and leasing grew by 0.5% in the month led by a 5.3% gain in output of real estate agents and brokers, mainly as a result of gains in the GTA.  At the same time, construction was the only sector in the goods producing side of the economy that showed an increase in the month at up 0.5%.    

So we have an economy whose growth will continue to be plagued by uncertainty around US protectionism, will likely get little support from oil prices, and is becoming more vulnerable to a housing correction at the same time that measures have just been taken to slow home price increases.   And don’t forget financial stability concerns surrounding Home Capital.  

In brief, the fundamental reasons that justify being short Canadian dollars against the US remain. With a Central bank extremely reluctant to move on rates,  it looks like this trade still has room to run.  

A Wynne-ing Strategy?

Recently in a church basement in downtown Toronto….

“Hello, my name is Ontario and I am a speculative bubble.” 

“Welcome Ontario.  My name is Kathleen.  I take it that this is your first time to one of our meetings?  We are heartened that you have recognized that you have a problem and that you would like to do something about it.  That truly is the biggest step.  Please relax.  I know this is suppose to be anonymous but you may recognize some familiar faces in the group from Australia, Asia and some cities in Europe.”

“Most of the people here are already familiar with many aspects of our 16 step program but let me just run over the basics for you.  The good news is that our program is painless.  The biggest step is the imposition of a property transfer tax of 15% on non-citizens and on those who are not permanent residents of Canada.  Vancouver, sitting in the back over there, went through the same thing and there was just some temporary mild discomfort.  For you, Ontario, they tell us that this will have even a smaller impact on you as about only 8% of buyers fall into this category.”  

“For pain management, we are imposing the tax only around the Golden Horseshoe.  Maybe this will push some of the speculative buying up to The Nation’s Capital.   If federal policy makers start seeing their home prices go up, maybe they won’t be so grumpy and envious…I’m just kidding.”

“The other big part of our program is that we will be implementing rent controls, keeping them at the rate of inflation with a cap at 2.5%.  Again, this should be relatively painless for you.  We were just trying to stop some people from using your state to take advantage of others.”  

“One last big thing. We want to put in place a vacancy tax once we figure out what that means.  Any questions?”

“You are not going to do anything about domestically-driven speculative activity?”

“Nope.  Those buyers will probably back off for a few weeks until they get a feel for how important the foreign buyer was to the price increases, but I’m sure fundamentals will reassert themselves in no time.”

“You are not going to do anything about new housing supply?”

“Well, we are doing something.  The Government had some acreage that they weren’t using so we will construct some low income housing.  It’s not that those people were driving the speculative frenzy, but it does look good.”

“What about the greenbelt around Toronto?  People tell me if restrictions were changed that could deliver significant amounts of new housing.”    

“Our program is designed to be painless for both our voters and the environment.  If we released too much supply, prices could come down too quickly.  We don’t want to hurt the boomers by risking their hard-earned housing lotto winnings.”

“And nothing is going to be done about interest rates?  I don’t have to suffer withdrawal from mortgage rates moving higher?”

“Well now that you have joined our program, that is all the Bank of Canada wanted to see.  They can wipe their hands clean now.  Now that you are a card-carrying member of regions carrying out macro-prudential measures against speculative activity, or MPMASA, they could even lower rates if they felt they had to once Mr. Trump milks NAFTA of its anti-American biases.   Doctor Poloz up in Ottawa has done some fascinating work recently on the subject, claiming that interest rates have no impact whatsoever on what is happening to home prices in your region.  It really is ground-breaking stuff.”

“Okay, so let me get this straight.  This program will help address my speculative sickness by directly attacking 8% of the problem and by indirectly tinkering on the edges of some other things.  I may have some very temporary side effects but they will probably subside in a month or so and now that I am carrying a membership card to MPMASA, this frees the central bank up to cut rates and give me a quick boost if they feel it is necessary because Poloz doesn’t think interest rates had anything to do with my predicament in the first place.”

“Yep.”

“I’m in.”

Unemployment: Poloz's Final Frontier

Let me be one of the first to welcome Captain Poloz and his spacecraft the HMS BoC back to reality from their recent intra galactic voyage.   The Bank’s latest version of the MPR seems to be more in tune with our world.  They finally acknowledged a number of data points that had been read by us earthlings as actually occurring but until this week appeared to be largely ignored by our monetary masters.  Don’t get me wrong, they are still claiming some economic relationships that may work only in zero gravity, but overall they have touched down, however briefly, and joined us in reality.

First, let’s look at their log book that recorded observations when the ship’s wheels hit the tarmac.  They acknowledged that growth had come in much stronger than they were expecting when they left in January.  The oil and gas sector getting up off its knees, strong demand for autos and, of course, an out of control housing market contributed to a surge in activity.  First quarter growth is now strong enough to give the Governing Council enough fortitude to say that interest rate cuts are now off the table.  The Governor during the press conference even said that the recent economic data was good news.  Now if he would only look like he meant it.  

Once they landed they also noted the housing market in the GTA and, given their reading off their price increase meter located on the bridge, concluded that there may be some speculation going on in the region.   They went as far as to include the housing market as a near term positive risk to inflation and to admit that it could also potentially create a macro and financial vulnerability in the future.   

Alas, this was all too much good news for them.  After admitting that economy is in a better place, they quickly reverted to their suck and blow approach to keeping financial conditions accommodative.  Before anyone should get excited about the possibility of increased rates or a stronger dollar as a result of a higher starting position, they stressed that they believe that the recent surge in growth and inflation are just temporary.  From now on, everything is down hill.   The material excess capacity in the economy will be slow to absorb and until every young adult leaves their parents’ basement and finds gainful employment you will have Captain Poloz keeping the shields up and continuing to demand lasers be targeted at non energy exports and be set on accommodation.  GC concluded, after pulling a new rabbit out of their hat with respect to potential growth, that the output gap will not close until the first half of 2018, ever so slightly sooner than envisioned in January.  Their message: Everybody calm down and buckle up in preparation for serial disappointment.  

Confusingly for us, when they create a narrative, they continue to defer to the economics text book they picked up while visiting Uranus University (known as U2 to the alum) on the transmission of monetary policy in zero gravity.  Economic relationships that apparently are theoretically robust in space, but don’t seem to be consistent with what most of us on earth deem to be reality.  According to profs at UU, interest rates have no impact on the housing market (or colonies).  Hell, as the Governor told us several times, rates could go to 5% and still not have an impact.  Those darn speculators are immune.  I remember in economics classes taken on earth, we were always taught that as a result of leverage, the housing market was one of the most interest rate sensitive sectors.  As a result, I am still going to believe an increase in rates would have some impact in cooling the housing market.  But again, a different world.  

More fascinating in zero gravity is that changes in interest rates apparently can have very concentrated effects. In space, changes in rates have no impact on housing investment but do leave an impression on other components of growth, including business investment.  The MPR tells us that the only sources of growth we have to look forward to in the near term will be household spending which will be supported by accommodative monetary policy (except, I guess, for anything to do with housing which is unresponsive to rates) and fiscal stimulus.  The next time GC departs into space, I hope further work will be done studying the elasticity of certain sectors to changes in rates.  Maybe try to understand why in space, rates can rise by 5% and have no impact on a bubbling housing market while at the same time business investment, which we are told is partially paralyzed by uncertainty around US trade measures, is hyper sensitive to the downside given even the slightest hint of a rate increase. On this planet, it wouldn’t matter to business investment if rates went higher.  It would be like stabbing two day old road kill.  

And while the crew is up there, they should track down the financial market literature on the role of “chunks” in dampening financial asset bubbles.   Even without gravity apparently some things can still go down.  The theory apparently states that since the speculator has to buy the entire house,  as prices go ever higher he/she will be unable to muster up sufficient funds to either buy a house or find a buyer who has the financing for the house he/she is trying to flip.  The market then falls under its own weight.  On earth what we are seeing as prices are going through the roof are speculators banding together and splitting any profits.  What we have is the price (known in space as “chunk”) divided by however many speculators want to be involved.  Suddenly the chunks are small again.  Heck, in the 905 region around Toronto, families are combining their incomes to buy one home to live in permanently together.  Having said this, it would be great to get a hold of the work done so we can be better prepared.  The last thing we all want to see is a market blowing out chunks.

The Governor concluded the MPR saying that they are now decidedly neutral.  The market seemed to view the acknowledgement of the stronger data as slightly hawkish.  With the captain of the spaceship convinced that there is excess capacity, and emboldened by low readings of core inflation, economic theories taken from both our world and from their travels will be used to create a narrative to justify extremely accommodative policy.  This is a captain a few years into his seven year mission who is nobly focussed on getting as many people working as he can before the asset bubbles he has created come crashing down on top of him.  He is going where no man sitting in his chair has gone before—unemployment below its natural rate (NAIRU).