On Friday the Canadian government released their most recent statistics on inflation. Economists were expecting CPI to rise at a 2.0% annual pace but the actual number came in at 2.3%. The CPI Core also exceeded forecasts with the YoY rate of 1.7% running hotter than the expected 1.5%.
As you would expect, the Loonie firmed on this news, pushing to new 5 month highs.
USDCAD rate (lower rate = CAD strength)</a> </div>
This hotter than expected inflation release is obviously putting the Bank of Canada in a bit of a bind. With the Fed taking a “fingers in the ears – I can’t hear you” approach to inflation, this leaves the rest of the world (including Canada) in a quandary in terms of their resolve in tightening monetary policy as inflation heats up.
It’s difficult for the Bank of Canada to argue that the trend for inflation is anything but higher.
CPI YoY Rate</a> </div>
The real question is how much inflation will the Bank of Canada will be willing to tolerate.
The Canadian monetary stance is already tighter than the US ZIRP level.
US 2 Year Yield (yellow line) vs CAD 2 Year Yield (white line)</a> </div>
My expectations were that the Fed was going to gradually tighten monetary policy while Canada tightens even more slowly, eventually reversing the spread between the two yield curves. However Yellen’s refusal to acknowledge the risks from rising inflation is going to delay this scenario. Eventually this extreme easiness from the Fed is going to cause the reversal between the US and Canadian rates to be all the more violent, but it has probably delayed its arrival.
My short 2016 Eurodollars vs long 2016 BAX futures trade had been slowly working, but took a hit on Friday’s news.
Mar 2016 Eurodollars (white line) vs Mar 2016 BA Futures (yellow line)</a> </div>
Although I don’t think Canada is going to lead the next tightening cycle, I am going to cover the position as I am worried about Yellen & Co.’s extreme dovish policies. I am still somewhat aghast at the responses she made during the last FOMC press conference. It is hard to conclude anything but that the Fed is going to be extremely slow in raising rates. In fact, it looks like they are only going to do it kicking and screaming.
The March 2016 Eurodollar futures contract has 100 basis points of tightening built into it. Although I expect the next year’s economic indicators to be extremely firm and that this 100 basis points not be be tight enough, I don’t trust the Fed to actually follow the yield curve higher.
Given the increasing inflation numbers out of Canada, and the Fed’s reluctance to acknowledge their increasing inflation situation, I think there are better trades out there than short Eurodollar vs long BAX. Heading to the sidelines on this trade…
Canadian and US housing
While I am on the subject of Canada I thought I would take a moment to talk about housing.
I was leafing through my old saved research file this week-end and I came across this article about the Canadian real estate market that quoted famed Canadian money manager Stephen Jarislowsky:
Feb. 12 (Bloomberg) – Stephen Jarislowsky, chairman of Montreal-based investment adviser Jarislowsky Fraser Ltd., said he is “convinced” there’s a bubble in Canada’s housing market, fueled by government measures that encouraged consumers to take on debt.
The date on the quote is February, but I purposely left off the year. Can you guess what year? Maybe last year? Nope. How about 2012? Wrong again. Surely it must be 2011. Unfortunately not. The quote is actually from February of 2010.
Let’s dial the chart of Canadian real estate to see what happened since Jarislowsky’s big call about Canadian real estate being in a bubble.
Canadian Real Estate Index</a> </div>
Now I don’t mean to pick on Jarislowsky, and I am certainly not a Canadian real estate market bull by any means. But I did want to show that bubbles can continue for way longer than even the wisest market veterans forecast. I guess to be fair Jarislowsky didn’t predict that the housing bubble would pop, he just stated that it was in a bubble.
And he is right. Canadian real estate is in a bubble fuelled by the excessive easy monetary policies of the Bank of Canada and the other Central Banks. But almost all financial assets are experiencing the same crazy bubble mentality. Whether it is collectible sport cars, high end art, junk bonds or even new technology stocks, these assets are all being pushed to absolutely asinine valuations. However what do you expect when the world’s Central Banks engage in the greatest monetary expansion the globe has ever seen?
All my American hedge fund friends love predicting the demise of the Canadian real estate bubble. I told them once and I will tell them again – Canada is going to frustrate them with our boringness. Our market is not going to crash spectacularly like the US real estate market did in 2008. It might go down slowly, especially in real terms, but real estate markets very rarely collapse like we saw in the US. That is the exception, not the rule.
The US real estate crash of 2008 left a scar that not only made American hedge fund managers see real estate bubbles everywhere else, but it has also stopped the US from inflating another real estate bubble. Have a look at the US housing market versus the UK and Canada.
UK Housing (green) Canada Housing (yellow) US housing (white)</a> </div>
It is not only Canada that is experiencing a housing bubble. Many other areas of the world are experiencing a real estate rally that is absurd. But given the madness that we have seen from the world’s Central Banks, buying real estate is an obvious response for most individuals.
The amazing development is not the real estate bubbles in places like Canada, Australia and the UK, but instead the fact that US has been unable to resurrect their real estate bubble. It just goes to show you that once a bubble pops it take a long time for it to reflate.
Most financial market analysts are busy predicting the popping of all the non-US global real estate bubbles. Although I understand their argument, I wonder if they are missing the easier trade.
This is a very out of consensus view, but what if instead of all the other real estate markets correcting downward, the US instead plays catch up? Most analysts are reluctant to forecast a rising US real estate market because valuations are somewhat stretched when compared to the last few decades.
But ever since the start of the great world Central Bank monetary expansion of 2009, when has valuation stopped any asset? I know this seems like a stupid argument and I can’t believe I am making it (we must be close to the top in real estate for sure), but markets often resolve themselves in ways least expected. Everyone is forecasting global real estate markets to correct downward like the US. It would be just like the Market Gods to throw everyone a curve by having US markets explode higher instead.