If Not Now, When?

This week, there is a high probability that the Bank of Canada will raise interest rates by 25 basis points.  To paraphrase the Governor, he wants to take his foot off the accelerator before the output gap totally closes.  However, according to some articles in the press and some commentary, this may be the beginning of the end for the economy and we are now about to go through the gates of hell.  The world of easy money, as we know it, is over.  You want to buy a house in the GTA?  Wait for two hikes and, according to some, you will be able to scoop them up by the dozen.  One of my favourite headlines was “when rates go up, borrowers will pay”.  That is something new.  Imagine having to pay for the use of money.  Worse still, imagine receiving something on your savings. 

Everyone, take a deep breath and calm down.  

Remember in the great Mel Brooks film Space Balls, Dark Helmut took his Space Ball One ship to “ludicrous” speed.  Well monetary policy, especially in Canada, where we were proud that we never had a systemic financial stability issue,  has been at “ludicrous” speed for the last few years.  Our Dark Helmut is now taking it back to “ridiculous” speed.   Even if rates went up 100 bp from here, monetary policy would still be considered accommodative.  

But according to many, the slightest decrease from “ludicrous” speed is going to risk a destabilizing decline in housing prices and an ensuing banking crisis.  A 50 basis point increase in the five year rate will increase a $250 k mortgage amortized over 25 years by about $70 a month.  About one Starbucks coffee a day.  If an individual has chosen to take on a mortgage payment with no buffer, and a lender has opted to take on this exposure, is it the Bank of Canada’s responsibility to immunize everyone from really bad decisions (or negligent compliance)?

The answer is no.  But they are also aware that when moving rates higher, there will be casualties.  The Bank has spilled plenty of ink on the vulnerabilities emanating from a highly leveraged economy concentrated in the household sector.  They have looked at the impact on the financial system of higher rates and higher unemployment on the sector.  They have determined that the impact of higher unemployment is much more detrimental than when rates increase.  The banking system, along with government regulators,  have also run their own stress tests to determine the impact on them of a housing collapse.  Whether you agree with the results of these stress tests or not, the bottom line is that the Bank does.  It is undertaking the first move, believing that if higher rates ultimately trigger a collapse in asset prices, the financial system would take losses but it would be able to absorb a substantial hit if it were to happen. 

So when the Bank of Canada starts to raise rates, it will be with its eyes on where they expect inflation to be in 18 months to two years.  If they raise rates this week, it is because they believe that the headwinds to achieve their inflation goal have lessened and they can let up on the gas.  They are initiating this move with unemployment at very low levels, reducing the risk of an adverse aggregate impact from housing on the financial system from slightly higher rates.   There could well be some borrowers who will become quickly stressed in the new environment and this will undoubtedly make headlines.  However, as a policy maker charged with setting rates, the focus is not on the individuals who have put themselves in a vulnerable situation but rather on the resilience of the overall economy and the financial system in particular to absorb these losses.  From the work done, the Bank feels confident that the chances of a repeat of the 2008 crisis, where problems in the financial sector propagated back into the general economy, are low.  

So, if the Bank does hike this week, they are starting from a point when the Canadian economy is one of the strongest in the world, unemployment is low (by our standards) and our financial system is resilient.  It would seem to be a good time to start to let up on the pedal.  If not now, then when?

Now What?

Just when it looked like the Bank of Canada may have a strong case to move rates higher, surprisingly soft inflation numbers were posted for May.  Headline inflation came in at 1.3%, the lowest this year, their old measures of core came in below the bottom of their target range at 0.9% and most importantly two of the three amigos (their new three measures of core) lost ground month-over-month, taking the average down to 1.33%.  The deceleration in inflation so far this year would usually be associated with an economy in distress, not one that is growing strongly.  For an inflation targeting central bank with a 2% goal, I confess it is hard to justify moving rates higher in the near term.   But let me try.

Monetary policy is forward looking.  In setting policy, where inflation stands today is less relevant than where inflation is expected to be in six to eight quarters from now when today’s stance will be felt.  Whether to move now depends on the Bank’s conviction that an economy at or near full employment will begin to encounter capacity constraints that will put upward pressure on prices between now and say 18 months from now.  Starting from a low level of inflation may well mean that the extent of total tightening needed to achieve the target may be less and more gradual, but it does not preclude starting the process of reducing stimulus now if they feel the current level of “considerable” stimulus is inconsistent with the current estimated size of the output gap, its pace of closing and what that means for inflation in a year or so. They need to respond today to their call for inflation in the future—not to the current price of oil or the current inflation rate.  

Setting policy based solely on current and volatile economic numbers subjects the Bank to being influenced by noise rather than signal.  The noise tells them that the price of oil is low, inflation is low, etc. but beneath these indicators are strong economic fundamentals that suggest that oil and inflation will find a base and start to move higher well before any tightening action taken by the Bank has any influence over them.  When the market starts to selectively pick the “noise du jour” to forecast upcoming Bank actions, they will always be able to find a reason for the Bank not to do anything.  For example, Canada has had a recent string of very strong economic data.  It is hard to imagine that this momentum can be sustained, especially given softer oil prices.  I can already hear the pundits when the first readings come out that the economy is slowing from its recent pace.  They will immediately insist that the Bank cannot tighten policy.  If they didn’t increase rates when the economy was growing near 3%, why would they now?  

All that being said, my argument that higher rates may be seen sooner rather than later is mute if the Bank has lost confidence in a domestic Phillips curve framework.  Perhaps Canadian  inflation reports are now more heavily influenced by global excess capacity that can be tapped in a cheap and timely manner and are now characterized by a continuum of idiosyncratic deflationary factors (automation, e-commerce, competition) that take turns keeping downward pressure on inflation.  In this case, regardless of the state of our economy relative to its potential growth, global deflationary forces dominate and keep inflation low.  This would suggest very low rates for a very long time and an increased risk to financial stability.  Under this scenario, with high levels of domestic household debt and an aging workforce in the background, there will never be a good time to lessen the level of domestic stimulus as it will always be argued that it is needed to offset these forces as long as they persist.   

So what world does the Bank of Canada believe in?  I think they still give credence to the output gap framework, believing that a domestic economy closing in on full employment will ultimately put upward pressure on prices.  Obviously, the current level of oil and inflation will be inputs into the Bank’s upcoming forecast and will be important factors influencing the profile of economic growth going forward, but their current low levels do not detract from the distance that the economy has already covered in reducing the size of the output gap.  Using this framework, the economy is closer to feeling the impact of domestic capacity constraints on prices than previously expected.  This would suggest to me that the Bank is closer to nudging rates higher than the market expects, despite the recent dis-inflationary readings. 

Will they or Won't They?

Boy can things change in a hurry when it comes to monetary policy expectations.  A few weeks ago the market was convinced that the first upward move in rates in Canada would wait until well into 2018.  In fact, it wasn’t that long ago that visions of rate cuts still danced in the head of the Governor.  Then in mid-month the Senior Deputy Governor acknowledged the stream of positive economic data that has come out over the last few quarters and voila, we suddenly have expectations for a rate hike moved into this year.  Some radicals are even saying there is a chance of a move in mid-July, given the Governor’s history of bold moves.  But wait, there’s more.  Now that the price of oil is suddenly in a bear market and groping for a floor, the take is that this will push any rate hike further back.  After all, they wouldn’t dare be raising rates when oil is at the same price that made them cut rates back in 2015.  What’s a person with a floating rate mortgage to do?

To figure it out, one has to look at where we have been and where we are going with respect to the output gap.  The economy has performed better than the Bank had expected, especially over the last two quarters.  Unless you believe that there has been a matching increase in potential growth, this would lead to a narrower output gap than the Bank expected in its last MPR.  So the starting point for this upcoming decision is from a higher level of GDP and with a smaller output gap.  

In a perfect world, as a policy maker, you would like to have your target rate back to neutral when the output gap is closed.  This would suggest the target rate should be in the neighbourhood of 2.5-3% by early 2018.  That is not going to happen.  We do not live in a perfect world and it is not hard to come up with reasons why rates should remain stimulative to offset numerous headwinds (debt, oil prices, Trump uncertainty, low productivity, blah blah).  The question is, as the Senior Deputy Governor asked, “whether all of the considerable monetary stimulus presently in place is still required?”

The fact that we are probably two quarters away from having the output gap closed, even with the economy slowing from its recent pace would suggest to me that the current degree of monetary stimulus is no longer required.  The Bank acknowledges that growth is broadening and, importantly that the oil price shock is mostly behind us.  This sector that was built on $100 oil has been pared back significantly since 2015 so any impact on the total economy from lower oil prices will be less severe than has been seen in the recent past.  The fact that oil is in the low 40s now is different than two years ago.  The actions that the Bank took in early 2015 are no longer needed.  They can make a very strong case to start the adjustment to higher rates as early as next month.

The adjustment to higher rates started with the Wilkins speech.  The question now is when does the Bank ratify that move and give us some idea of the slope of the increases.  The July MPR gives the Bank the opportunity to act and explain why less stimulus is needed now.  Through its economic projections that will include assumptions around uncertainty, housing, household debt and the currency, they will also give us a sense of the profile of any further rate increases.  My hope is that the Bank does not delay and will start to pull back on the current level of stimulus, getting us closer to an appropriate policy setting.  

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.