NORTH AMERICAN & INTERNATIONAL ECONOMIC HIGHLIGHTS
1. It seems that the Bank of Canada is signalling that it will begin raising rates in the summer, if not sooner. What is the expectation for the overnight rate for the next 24 months?
By now it is clear that the Bank will move by June or July. However, we expect that the first leg of tightening will be moderate (only 75 basis points in Q3 of 2010) and the bulk of the tightening will be in 2011. Look for the overnight rate to reach 2% within 24 months.
2. How do you see the Canadian yield curve reacting to that forecast?
We expect some flattening in the yield curve in the next six months as short-term rates catch up with-long term rates. But we also expect to see a steeper yield curve down the road; the need to raise short-term rates will be limited by a softening economy in the second half of the year, deleveraging by consumers and government policies that will start acting as a negative for the economy. At the same time, we expect some upward pressure on long-term rates due to fiscal consideration and some inflationary fears.
3. Some of your peers have commented on the Bank of Canada raising the overnight rate while the Federal Reserve Bank maintains a near-zero target for the federal funds rate. Is this really a sustainable course of action for the Bank of Canada and how do you see this playing out?
No. That’s why we expect the first wave of tightening to be limited. There is a limit to what extent the Bank can fly solo without the Fed. Note that it happened in the past-1992 and 2002-where the Bank moved independently of the Fed only to reverse these moves a few months after. We think that most of the increase in rates will be in 2011 when the Fed starts moving.
4. Briefly, what is your thesis on the outlook for the US and Canadian housing markets?
Over the past two years, the degree of volatility observed in the Canadian housing market has been unprecedented. Within this short time frame, house prices fell by almost 13%, only to rebound by an impressive 21%. Meanwhile, resale activity is now rising by close to 67% on a year-over-year basis after falling by close to 40% in 2008. Housing starts are presently 33% higher than in April 2009, despite dropping by more than 50% earlier in the recession. In fact, no other segment of the economy has rebounded as quickly as the housing market, making it one of the real surprises of this recession. This rapid uptick in housing activity, in the face of recessionary conditions elsewhere in the economy, raises concerns about its sustainability. It’s causing some to wonder whether house prices are rising too quickly given current economic fundamentals.
Using a recent International Monetary Fund (IMF) housing valuation model as a base, and updating it to reflect the most recently available Canadian data, we estimate that the Canadian housing market as a whole is beginning to overshoot its ‘fair value.‘ At just under $350,000, the current average price of a home is estimated to be roughly 7% over what would be consistent with current housing market fundamentals, including interest rates, income growth, rents and demographics. However, that modest overshooting is far from uniform across the country. Those figures are skewed to Western Canada, which has seen the most dramatic swings in house prices over the past 24 months. That market now appears to be overvalued by roughly 10% to 15%, suggesting that the imbalance in the rest of the country is much more modest.
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