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Rates, Inflation….what does this mean?

General Angela Calla 19 Oct

Post Date: Friday, June 19, 2009

Recently a reader of my blog asked me to comment further on the relationship between interest rates and inflation, and the performance of the market.

With respect to the first part on how interest rates and inflation are related you need to understand that there are economic laws at play with these two itmes. Inflation ALWAYS affects both short term AND long term interest rates in two very different ways.

With respect to long term rates, you need to remember what drives long term rates, that is long term bonds. Therefore one needs to know that as inflation rises bond yields ALWAYS go up. When bond yields go up (as they have been steadily for the past 6 weeks) then fixed rates ALWAYS go up. As for how that affects the stock market, TRADITIONALLY as bond yields rise people flee the stock market which then does bring the stock market down in lockstep as bonds rise. Couple this with the expectation that there will be periodic profit taking from the stock market as there has been recently and you can wit certainty predict that the stock market will continue to be volatile for 12-18 months as we navigate inflation rising.

With respect to short term rates remember that variable rates are priced off short term t-bills or Bankers Acceptance rates. Those rates are determined solely by the central banks overnight rate. TRADITIONALLY, the central banks ONLY weapon against inflation is to raise the overnight rate. As this happens of course then variable rates go up.
What does all this mean with respect to the real estate market then?
Well, first we would all do well to understand and accept that the ONLY reason we have seen a quicker recovery to the real estate market is SOLELY based on the fact that both long and short term interest rates are at significantly historical lows. That means readers would say “based on what Angela said above if inflation rises (which EVERYONE expects that it will) then interest rates will rise respectively, which will cool the recent rebound in real estate.”

The answer to this is “not necessarily”. Let me explain in point form below:

1) Short term rates may not go up as fast as inflation this time around
There are two reasons for this, number one is that the Bank of Canada has repeatedly said recently that they are not going to touch the overnight rate until June of 2010. However they have also been adding the caveat recently that they may change this stance if inflation surges out of control. My guess is that they will let inflation get slightly ahead of their comfort zone, and then attack it, which means we will get a the rest of this year and maybe Q1 of 2010 at these unbelievably low variable rates.

The second reason is that as the banks cost of funds continue to drop and they start reducing the risk premium they have been attaching to their loan pricing they will drop their premiums over prime to gain more market share. This has already been happening as a few months ago the best deal you could get was Prime +.80% and today you can get Prime +.45%. Look for this premium to be dropped all together in the coming months, and likely we will be back into Prime Minus within a year or so.

2) Interest rates are sooo low now

What I mean here is that even if interest rates were to rise by 1 to 1.5% in the coming year we would STILL be below “normal” historically. Therefore how much would this cool the real estate market?

3) Never bet against momentum

As interest rates start their slow climb back to normal levels many people will panic and get into the market to buy “before rates go higher” this momentum will gain steam as it goes. We will likely continue to see a strong real estate market with strong demand as rates rise. Of course as rates rise above say the 5% level again then affordability becomes an issue. If strong demand causes a bigger then expected rise in average price, coupled with a decline in affordability then remember what we learned in the last crash as soon as average home prices start to overshoot our growth in family income then you can absolutely predict with certainty a real estate correction. This time we will be ready.
With Oil rising quietly lately and the fact that it will likely be over a $100 or close to it by years end and the fact that the US money multiplier will rise (more of the billions they printed to get out of the banking crisis enter the market) you can count on inflation. But don’t count on that shutting down the real estate market in the short run. It will be a few years before we will see a cooling or an outright correction. Tread carefully.

As a final note, PLEASE anyone taking a new mortgage today, or any of my colleagues selling mortgages today, make sure you can afford the house you are contemplating if interest rates were in the 5 to 5.5% range. better yet, set your payments today as if the rate WAS 5.5%. Why?
because when you renew five years from now, count on the fact that it will be that or maybe higher, and that you will likely have moderate equity gain in that time period and you will not be able to count on a refinance to bail you out.
Let’s not repeat our past mistakes, gluttony is a cardinal sin remember.