Did Bank of Canada just crash the Canadian property market?

Did Bank of Canada just crash the Canadian property market?

By Lars Christensen, Founder & CEO, Markets & Money Advisory

The main news story today in the Canadian financial media is the spectacular drop in the share price of Home Capital Group today.

This is from Canada's leading financial newspaper the Financial Post

Shares of Home Capital Group Inc. plunged 65 per cent Wednesday after the embattled mortgage lender said it was seeking a $2 billion line of credit to backstop a significant decline in deposits at its subsidiary.

Home Trust has seen deposits drop by nearly $600 million in recent weeks and Home Capital said that it expects the withdrawals to accelerate.

The mortgage lender said that the terms of the proposed credit line — negotiated with “a major institutional investor” — would “have a material impact on earnings, and would leave the Company unable to meet previously announced financial targets.”

Analysts suggested the loan could come with an effective interest rate as high as 22.5 per cent on the first $1 billion.

Home Capital said the non-binding agreement in principle would be secured against a portfolio of mortgages originated by Home Trust.

“Access to these funds is intended to mitigate the impact of a decline in Home Trust’s HISA (high interest savings account) deposit balances that has occurred over the past four weeks and that has accelerated since April 20…. The Company anticipates that further declines will occur, and that the credit line would also mitigate the impact of those,” the company said.

Home Capital added that it expected a “firm commitment” for the loan facility on Wednesday.

Home Capital Group's financial problems clearly raise questions about the state of the Canadian property market and also in a broader sense about financial stability in Canada and it is hard not to see the similarities with the US subprime crisis. 

However, as with the subprime crisis - which turned into the Great Recession - we would argue that this is less about a property market bubble bursting than about monetary conditions becoming too tight. 

In fact we have for some time been warning that the excessive tightening of Canadian monetary conditions could cause major troubles for the Canadian economy - and we now see maybe also for the Canadian financial system. 

Subscribers to our monthly flagship publication Global Monetary Conditions Monitor (GMCM) would know this. Hence, in the March edition of GMCM we wrote:

Not all countries are doing equally well, however, and there are certainly several where monetary conditions are excessively tight. Here we would particularly highlight Australia, Canada, Japan, Singapore, and Switzerland as places where monetary easing is warranted to hit inflation targets in the medium term.

...Nevertheless, further monetary easing – for example, through weaker currencies – is certainly warranted. Canada is a more extreme case.

Here monetary conditions are too tight and at the same time have become even tighter in recent months. Logically, the Bank of Canada (BoC) ought to take steps to ease monetary conditions, but it is very clear that that BoC is struggling mentally and institutionally with the notion of easing monetary conditions at a time when the key policy rate is close to the Zero Lower Bound.

Unfortunately, the BoC does not seem to fully recognise the extent of this problem. So far, it has taken no major steps to convince us or the markets that it is ready to adjust monetary policy appropriately should further negative shocks hit the Canadian economy – for example, further declines in oil prices. 

Hopefully, the Bank of Canada now gets the message - there is an urgent need to ease monetary conditions in Canada and there certainly is no reason to postpone it - the longer monetary easing is postponed the greater the risk of the slowdown in the economy and the cooling of the property market turns into major financial distress and potentially a deep recession. 

The graph below shows our measure of monetary conditions in Canada. A value below zero indicates that montary policy is too tight to ensure that the Bank of Canada will hit its 2% inflation target in the medium-term.

As interest rates now are basically stuck at the Zero Lower Bound monetary easing needs to be implemented in other ways.

The most obvious thing to do would be to announce an open-ended quantitative easing program with the aim of keeping nominal demand on a stable path.

Monetary easing can also be implemented by intervention in the FX market to weaken the Canadian dollar. No matter how such easing is implemented it seems clear that the implication will have to be a significant weakening of the 'loonie'. 

In our next edition of Global Monetary Conditions Monitor, which will be published on Friday we will write more on the need for urgent monetary easing in Canada.

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