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Speculation Stumbles - Central Banks React

Updated: May 27, 2021

Markets across asset classes are in a chaotic speculative frenzy. Is real estate any different?

NFT mania, Archegos family office $10B blow-up, Dogecoin rocketing ‘to the moon’, and SPAC obsession have caught the eyes of investors across the board. Speculative asset bubbles in multiple markets have popped and struggle to regain footing.

At a time when front page news plastered images of Capitol Hill being stormed and Donald Trump trying to maintain power, I was ringing different alarm bells - a real estate bubble building that we hadn't seen in over a decade.

As discussed in the previous article, real estate continued to ramp, home supply increases had no dulling effect on prices, price acceleration decreased while absolute prices rallied, and all major central banks [CBs] began discussing tapering quantitative easing [QE] programs.

With CBs discussing and enacting QE tapering, what happens when the music stops? Are we in a real estate bubble bigger than that prior to the Great Financial Crisis [GFC]? Is it about to pop?

Before we begin, let’s recap our local Vancouver market for the month of April.

Vancouver Froth Is Not Gone:

Real estate usually begins to heat up as the temperature does, however this year is an exception. With dramatic heat in the market already having occurred, and a major lack of immigration demand, Vancouver sees slight cooling for the month of April. By no means does this mean the market has left its manic stage.

Sales-to-active listings ratio remains sky high. We have slowed down, but we are not close to a balanced market:

Sales-to-Active Listings Ratio by property type

When combining townhomes, condos, and detached, we are still 30% hotter than what analysts consider a balanced market:

Sales-to-Active Listings Ratio composite

While homes continue to sell at a frothy pace, we still have plenty of inventory flooding the market as sellers capitalize on an opportunity to cash in:

Total inventory rises month-over-month

With the market hot and plenty of inventory available, median sales price continues to rocket to all time highs:

Median sales price reach over $900,000

Have an idea of where our local Vancouver market is? Good. Let's zoom out and see what’s happening across the world.

Global Markets Shake

From Canada to Korea and everything in between, leverage and speculation has never been higher.

US investors trade with leverage >300% relative to the past decade.

Korean derivatives markets are seeing the highest volumes on record:

Leverage in Korea piles up, leading to greater volatility.

ETFs see twelves years worth of inflows, in five months:

No cash on the sidelines as everyone enters a ballooning market

It’s not just the stock market seeing speculation, investors in real estate markets are purchasing cash flow negative units in anticipation that the market can only go up:

CIBC economists promote purchasing significantly cash flow negative condos, as prices ‘only go up’

However, it appears the music has stopped for speculative markets with CBs discuss tapering QE programs and prospect raising rates:

Bitcoin crashes 30% in one day and 40% from its highs

Newer IPOs fall 27% from February peak, signaling decreased optimism.

ISPAC index falls 31% from its recent peak as investors lose enthusiasm.

Non-profitable tech stocks fall 34% from recent highs as reality strikes.

“Have fun staying poor”? Dogecoin crashes 50% from its all time high set in mid May, indicating a potential short-term top in speculative cryptocurrencies.

Speculative markets are dying faster than most people believed possible. What does that mean for real estate?

Is Real Estate a Speculative Bubble?

CBs artificially prop up asset markets

In several previous articles, I explained just how high real estate prices have become, but in case you need a recap:

Vancouver, Toronto, and Hamilton take the podium for the least affordable cities in North America

Benchmark year-over-year Canadian home price increases go vertical, higher than anything seen before.

US Housing year-over-year median sale price percentage increase moves beyond pre-GFC peak of 16.6% in 2005, flagging unsustainable and irrational momentum.

20% of Canadian mortgages go to over-leveraged borrowers, beyond that of 2016 levels pre-mortgage stress test

High prices alone do not constitute a bubble. What does, is the irrational behaviour for price increases. People disregard the amount paid for a home as they believe it will be worth much more in the near-future. In many cases, paying $30-$50k more than what a comparable sold for a few weeks earlier.

To quote Richard Vague’s ‘A Brief History of Doom’,

“...Financial crises recur so frequently and are so often linked to rapid increase in lending that we have to wonder why lending booms happen at all. The answer is this: growth in lending is what brings lenders higher compensation, advancement, and recognition. Until a crisis point is reached, rapid lending growth can bring euphoria and staggering wealth. Lending booms are thus caused by an intense desire to win, to prevail, and to increase wealth.”

We are in a speculative real estate bubble. How did we get here and what happens next?

Central Banks Control the Music:

Growth in lending and the significant asset price inflation that comes with it, is the result of central bank policies. Either BoC Governor Macklem is an idiot, or he knew exactly what he was doing. I am not sure which is worse.

The BoC is only part of the problem, but a big one at that.

After telling Canadians to borrow as much as possible for the past year, assuring rates would stay low forever, Tiff has finally admitted that “the recent rapid increases in home prices are not normal”. A 180° flip of messaging in a mere matter of months.

The BoC released the following chart stating that investor demand has not been a significant contributor to the current housing boom in Canada:

Investors purchase 1/5th of all homes in Canada due to ease of credit and rapid price acceleration

This is simply a lie. When investors made up 15% of new mortgages in the UK in 2015, the BoE warned there was “a threat to the country’s financial stability”.

From the onset of Covid-19, CBs around the world began or dramatically ramped up QE programs, leading to significant increases on their balance sheets:

G7 CBs combined balance sheet goes vertical to $25T as asset purchases run rampant.

Recall that QE is where a CB buys its own government bonds or other financial assets, in order to inject money into the economy and expand economic activity. This bidding up of the price of bonds lowers the interest rate, which extends itself to other rates such as those on mortgages and corporate loans. The levels of bond buying we have seen during Covid-19 are unprecedented and led to unprecedented asset inflation. In a QE environment, the reward for being responsible with money and saving is being left behind. Rewards only come from recklessly levering up and speculating in assets.

With out of control inflation in the markets, and speculative products exploding, central banks are coming around to the notion that the music must stop.

Central Banks Discuss Tightening:

As the world reopens and less support is needed, CBs are expected to begin tapering asset purchases sometime this year. The rate of tapering will be extremely important in order to not shake equity markets, or have the rug pulled on those levered up heavily on homes. If CBs wish to not have their country’s assets crash, tapering and a rise in rates must executed with surgical precision.

Analysts expect CB purchases to slow during 2021 and 2022

The Fed’s Undeserved Attention:

Despite the media focusing heavily on the United States and “JPow” memes of “the printer goes ‘brr’”, the Fed’s QE program is moderate relative to other countries:

US Federal Reserve receives undue attention as it holds the least federal debt when compared to its peers

Q1 Major CB balance sheets cross $25T and 57% of GDP to keep economies afloat

The Fed’s Total assets now equal 35.5% of US GDP, vs BoE’s 38%, ECB’s 76%, and BoJ’s 130.4%.

The US Federal Open Market Committee [FOMC] maintains its monthly $80B treasury buying, plus an additional $40B mortgage backed securities. US Treasury Secretary Janet Yellen hinted at raising rates in April, and Dallas Fed President Robert Kaplan has been shouting to raise interest rates. Chief of the Federal Reserve, Jerome Powell, acknowledged some asset prices are “high” and that “you are seeing things in capital markets that are a bit frothy”, but stated there will be no rate rise until 2024, let alone prior to 2022.

The Fed owns >30% of MBS - helping inflate home prices by keeping rates low.

Goldman Sachs expects the FOMC to hint at tapering in the second half of 2021, and begin tapering at $15B during 2022.

While Powell states no rate hike until 2024, derivatives markets brace for a hike in the second half of 2022:

Derivatives markets see a rate hike as soon as late 2022, could they be right?

The Bank of Canada Tapers:

The Fed’s QE program pales in comparison to the BoC, where it funds nearly the entire deficit and owns an incredible >40% of the entire Government of Canada [GoC] bond market - 235% greater than the Fed:

The BoC has funded 92% of the GoC budget deficit. $302B of $354B GoC debt has been purchased in the past year.

After an explosive expansion of the balance sheet in the past year where 70% of the BoC’s total assets became GoC bonds, Canada has begun tapering its QE program from $4B/month to $3B/month, allowing assets to mature and not reinvest at the same rate as previously done:

The BoC carefully reduces its QE program by 25% to not scare markets prematurely.

The BoC is on track with its goals, having reduced total assets from $575B to $475B at the end April. During all of 2020, the BoC emphatically stated there would be no rate hikes until 2023 at the earliest. This statement was repeated late 2020 and February this year. However, in April the BoC stated they will hit inflation targets ahead of schedule and likely raise rates mid 2022 or perhaps even sooner.

Perhaps unbeknownst to BoC Governor Tiff Macklem, this flip-flop attitude has dramatic effects on the most important long term investment decision of people’s lives. Canada’s QE program continues to brew a housing bubble that should not be tolerated by those on the left or right. The former see it as buying government bonds and depressing rates, benefitting equity holders, asset owners, rich and old, and entrenching wealth/race inequality while punishing laborers. The latter see it as huge deficits and zero price discovery.

In May, Macklem acknowledged that QE can widen wealth inequality and inflationary pressures derived from QE can be tougher on poorer Canadians and those on fixed incomes. This is his first acknowledgement of the dramatic K-shaped economic recovery, over a year into the pandemic.

Canadian home prices grow more in one year, than the previous five combined - enabling a K-shaped recovery

Sorry Tiff, but a 1% tax won’t stop a K-shaped market while credit remains cheap

QE programs around the world bring a K-shaped recovery. Macklem admits this 15 months into the pandemic QE program.

Millennials struggle to gain wealth as the K-shaped recovery takes hold

The Bank of England Tapers:

Across the pond, the BoE maintains its policy rate at 0.1% but has echoed the BoC in tapering its own QE program from £4.4B to £3.4B.

The BoE nears £1T of assets prior to announcing tapering its QE program

Although the BoE clearly is instituting a taper program, they stated that it is an “operational decision” that “should not be interpreted as a change in the stance of monetary policy”. BoE governor Andrew Bailey emphasized that this “is not a tapering decision” as the BoE left its target for the final level of QE assets unchanged.

Unlike the Fed, the BoE does not have open-ended QE, and instead has a goal of £875B UK government bonds and £20B corporate bonds, for a total of £895B. In reality, it is clear that the BoE does not want to use the term ‘taper’ as it would scare a volatile stock market and over leveraged home buyers.

Taking advantage of loose financial conditions, UK mortgage lending goes vertical to all time highs of £12B.

Net mortgage borrowing in the UK reached £11.8B in March, the previous peak being £10.4B when the UK was running up to the GFC in 2006. Whereas now it has already fallen off a cliff, having last year suffered its biggest drop in economic output in 300 years.

The European Central Bank Holds Out:

Only second to the BoJ in holding federal debt, the ECB’s total assets rose by €20.4B to a fresh all time high of €7.59T. Unlike its peers, central banker Lagarde maintains the QE program - 76% of GDP:

ECB balance sheet reaches an astonishing €7,588.8B and holds off on any taper talk.

Recognizing Trouble, Smaller CBs Tighten:

In an effort to save their currencies from out of control inflation and an asset bubble crash, Norway, Brazil, Turkey, and Russia all raise rates; and Sweden’s Risbank is on track to completely end its QE program later this year. Notably, Iceland too raised rates to 1%, the country that was the first to do so prior to the GFC.

After extremely loose financial conditions saved countries from complete devastation, they are equally realizing rates must be raised for the same purpose.

Central banks have created asset bubbles across numerous markets and are yet to completely acknowledge and correct their doings, what happens from here?

The Global Reopening Struggles:

Financial conditions that inflate asset prices continue to remain the lowest on record:

Favourable financial conditions result in continued high investor demand for assets

The IMF expects the largest global rebound in 40+ years:

The International Monetary Fund [IMF] forecasts annual GDP year-over-year at the highest level in 40 years at 6%, after a 3.3% contraction last year that was the worst peacetime decline since the Great Depression.

Covid-19 slowly becomes less of a problem across major countries:

The world sets the stage to reopen

The world reopens in major cities

While good news floats about, the world still faces one major issue: supply shortages.

Supply Shortages Inflate Prices:

Despite your uncle posting lumber memes on Facebook, supply shortages aren’t just affecting one industry, it's everywhere.

Used vehicle prices rocket as new vehicle production slows

The US sees supply-chain disruptions, port congestion, and chip shortages affect durable goods orders

Shipping prices rise multiple times over the five-year average

This issue extends into home improvement and homebuilding. Due to the large amount of recent home purchases, demand for home improvement-related goods has increased dramatically:

Home improvement searches double from February to April

Homebuilding struggles as commodity prices spike due to high demand and lack of supply. Eager developers must instead hold off as costs are too high and unpredictable. The same low rates which pushed building demand are the reason why it now cannot be done.

Authorized housing units where building hasn't actually started yet is at the highest level since 1979

April housing starts and building permits much weaker than expected

US existing home sales miss expectations, with only 1.16 million homes for sale

Lumber alone increasing 377% year-over-year, resulting in much fewer homes being able to be built with $50,000 worth of lumber.

Average finished new home inventory -82% year-over-year, with 88% of builders having zero finished new homes on average per community

With the Fed not completely admitting monetary tightening will come, and home supply diminishing, it is not surprising that individuals expect home prices to rise over the next year:

me prices would sink.

Bullish price expectations in housing now exceed that prior to the Great Financial Crisis

Ironically, buyers rushing to projects in a panic stating they need to buy now because the government is pushing prices beyond their reach, is what is causing the builder demand for labour and resources. If buyers eased, developers and home prices would sink.

What Happens to Canada From Here?

In my last article, I touched on how the Canadian dollar is in a peculiar position. This has continued. With commodity prices continuing to boom, Canada must actively devalue the currency as much as possible as an export country. Unfortunately, this happens via low rates. The same low rates which inflate asset prices and further wealth inequality.

There are policies such as taxing home equity which Canada could implement to dampen home prices, yet it refuses to. RBC and the Globe’s editorial board have both argued to implement a home equity tax, RBC stating “home prices at this level can have a destabilizing effect on the whole economy” . With real estate climbing to unsustainable levels across the globe, other countries such as France, New Zealand, and South Korea are moving to eliminate property tax advantages through taxing home equity.

The International Monetary Fund [IMF] has pushed Canadian banks to ensure borrowers can cover higher interest rate payments in the future, and as a whole mitigate systemic build ups of leverage. Canada’s Office of the Superintendent of Financial Institutions [OSFI] has responded with implementing measures beginning June 1st, but it is perilous relative to the amount of leverage currently built up.

To illustrate Canada’s reliance on real estate as the economy, a quick comparison between the US can be done. London sees 300%+ the gains of Cleveland, just across the river:

Cleveland with 600% gains year-over-year, London Ontario with 20,000%

This does not include recent large gains in Q1 2021

While a raise in rates across the world seems inevitable to avoid further inflation, Canadian Secretary for housing Adam Vaughan has stated a 10% drop in real estate prices is unacceptable. Yes, after a 30% run up in the past twelve months.

This sentiment by Vaughan is unsurprising, he sees homes not as a place to live in, but an alternative for financing retirement systems and therefore supporting price inflation:

Homes aren’t meant for living in, they’re an ATM

Vaughan has spoken further, stating that Canadian housing is “a market that’s driven by speculation” and that “we’re a very safe market for foreign investment but we’re not a great market for Canadians looking for choices around housing”.

In order to keep pushing house prices higher to drive our economy, those in power are choosing to serve foreign speculation and not Canadians. Despite red hot overheated real estate markets, nothing in the Federal budget is geared towards cooling Canada’s housing market.

Central banks control what occurs next. With all major CBs hinting at tightening to reign in inflationary pressures, it is inevitable that the real estate market will cool down from here. The rate rise will not be tolerated well by Canadians. Those levered up heavily will face severe problems when refinancing, and the economy will suffer when the Canadian dollar appreciates more and export prices on commodities increase.

In a best case scenario, supply chains heal and commodity prices retreat; resulting in a Canadian dollar rally with rising rates being tolerated well by those importing Canadian commodities. Simultaneously, vaccination progress could allow immigration to reopen, leading to greater housing demand capable of absorbing higher rates.

The next several months will be critical. Tiff Macklem and the BoC will have to steadily walk a tight-rope they put themselves on. A significantly levered real estate market keeps the economy afloat and it cannot be allowed to crash.

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