The Impact of Changing House Prices on GDP in BC

Source: https://www.armstrongeconomics.com/markets-by-sector/real_estate/real-estate-in-decline/

Yesterday (11th of July 2018) the Bank of Canada continued to increase interest rates, as many expected. 

Since the increase in the interest rate, the media coverage has been flooded with conversation around the impact this will have on homeowners. Specifically, it is well presented that Canadian households currently have a pile of debt and will have trouble continuing to service their debt if their payments or obligations increased. you can read a Bank of Canada article on the subject here.

Building off of these discussions, although quite separate, I began to wonder. Here in BC the Finance, Insurance and Real Estate (FIRE) industry make up essentially 25% of our provincial GDP.

As governments continue to engage in policies which aim to make housing more affordable (decrease or slow price growth) and as the Bank of Canada continues its upward movement of interest rates (decreasing the demand and supply of real estate); we have some serious headwinds on house price growth. The question of interest then: Given the size of the FIRE industry in BC, for some change in the house price, how does this filter through to impact our provincial level of output?

To answer this I conducted a simple time-series analysis which allowed me to jointly model both house prices (Teranet national bank composite house price index for BC) as well as the provincial GDP (Statistics Canada).

In order to ensure stationarity, these variables have a log-difference transformation applied to them, giving them the interpretation of the annual percent change. Each can be viewed independently below:

With these variables, I then apply a one standard deviation shock to the transformed House Price Index (HPI), which works out to be about a 4.6% point annual change in the index. Observing how this shock filters itself through both the HPI and GDP over time we see the impact of this shock. This impact is presented below.

First, evaluating the impact of a 4.6 percentage point shock to the House Price Index (HPI) on itself. What we witness is no big surprise, the housing price index jumps in the shocked year (year 1) and then slowly returns to it's normal. With a 95% Confidence level, this shock to house prices has been fully absorbed within 2 and a half years.

Recall we are dealing with growth rates here. Imagine the HPI is doing its thing, then, out of the blue, it jumps by 4.6 percentage points. the effect is an immediate increase in the index, followed by 2 and a half years of additional (but slowing) growth before returning to its pre-shock level of growth. 

Looking at the impact of a shock to the HPI on GDP we witness an impact which was expected. Our shock happens in year one, however, this does not filter through to impact our level of GDP until the second year. At this point, the GDP jumps to an estimated increase of 2 percentage points (fairly large given average growth rates of GDP). However, this impact quickly subsides and is showing no statistical effect 2 and a half years after the shock.

Through this, we can determine the elasticity of GDP to the HPI (for some % change in HPI, what is the impact on the % change in GDP). Thus we can determine the elasticity of GDP to be 0.435, meaning that GDP is not overly sensitive to a change in the HPI, that is GDP would be inelastic. Just the same we can take this to mean that for a 1% point change in the HPI, we would expect to witness a 0.435% point change in the GDP.

So, if we do see a collapse of house prices, this may filter into a bad few years for the BC Economy. Keep in mind, in 2014 when oil prices collapsed causing Alberta's GDP to collapse, Oil and Gas (with support services) accounted for aproximately 8% of Alberta's GDP. Given BC's reliance on the FIRE industry (25% of GDP), a collapse in the price of real estate could very well have a major impact on our provincial economy.

What are your thoughts on this, feel free to comment below.

Rate Increase

Source: http://eldercarebroker.com/wp-content/uploads/2016/08/rateincrease.jpg

Old news by now, but if not aware, Bank of Canada increased the overnight rate by 25 basis points from a rate of 1.00% to 1.25%

I posted briefly about this as well as a link to an article by Don Pittis at the CBC outlining the headwinds the Canadian economy is facing.

Although I never commented ahead of time as to what I predicted would happen, I will say I was pleasantly surprised by the rate hike.

That is, my thought (with nothing but anecdotal evidence to support) was that interest rates would remain at 1.00% for the time being. The rationale for this was:

• There is a lot of uncertainty regarding the future of NAFTA, if this is at risk of being canceled, this could be a serious negative shock to Canada's Economy.
• Increase in the minimum wage may have a similar impact (however also may cause cost-push inflation).

On top of these two headwinds, we also have the effect that increasing interest rates have on consumption, and thus output. That is, an increasing interest rate acts as a negative shock to consumption, and thus to aggregate demand. Keep in mind, this is the big reason why the BoC wants to increase interest rates, as this effect cools inflationary pressures.

This is also the rationale I have when I state that I was pleasantly surprised by the interest rate hike. As we have watched Canadian debt levels explode over the last few years, it seems that an increase in interest rates is required to cool this growth in debt. 

What are your thoughts on the interest rate hike, with another expected 3 hikes this year, is this too much too fast or just what we need?

feel free to comment below.

Looming increase in rates?

Image Source: https://economictimes.indiatimes.com

Don Pittis has a decent article here on the role Bank of Canada has in the Canadian economy and how they have to temper their decisions based on the current political realities of the time. Primarily the increasing minimum wages (Ontario and Alberta) as well as considering a possible end of NAFTA.

The bank of Canada is mandated to maintain a stable inflation rate bound between 1% and 3%, the big politics of late have even bigger economic ramifications which will ultimately affect how the Bank of Canada responds.

Keep in mind when the Bank sets their interest rate we expect it to take 8 to 24 months for the monetary transmission mechanism to fully work through the effect the actual economy.

What are your thoughts, should we expect an increase in interest rates coming up?

Almost Half of Canadian mortgages up for renewal next year.

Bank of Canada has recently released a report on Canada's financial system and the risks presented to it. the full report can be found here.

Although there was a lot of interesting insight into the Canadian mortgage and debt situation of Canadians, the part which really stuck out to me was that 47% of Canadians are set to renew their mortgages within the next year. Expanding this out, 78% of Canadians will be renewing sometime between now and 2020.

On this there has been a lot of talk of the renewal shock, shouldn't be a surprise that interest rates have been creeping up over the last year. Thus at first glance, I bought the whole renewal shock argument.

I then started thinking back to about 5 years ago when I was underwriting 5 year fixed rate mortgages typically at about 2.99%. Fast forward to today and the local bank is advertising 5 year fixed rates of 2.84%, jumping on to "ratehub.ca" shows an even lower 5 year fixed rate of 2.69% currently.

Although I don't recall giving out many rates lower than 2.99% looking back at ratehub.ca - it appears that during the spring early summer of 2013 rates fell to a low of 2.64% before rising to a high of 3.68% (I do remember when this spike happened).

The end result is that through most of 2013 rates were on par or higher than rates are today. Taking a ceteris paribus approach that today's 5-year fixed rate will more or less stay constant through 2018 means that the 47% of Canadians renewing this year will be renewing at a similar if not lower rate than their current mortgage contract.

It is not until about the end of 2014, early 2015 that the 5-year rate dipped below current rates. That is if rates were just to stay constant, those renewing in 2019 and 2020 will likely see a higher rate on their renewal than they had on their previous contract. likely this will not be a problem though as these families have also likely seen their incomes grow over this time period.

All this to say, Although it is interesting that we have such a huge bulk of mortgages entering renewal in the next year, it may be much ado about nothing. likely many of these households will be renewing at contract rates similar to their previous, and thus unlikely to see a payment shock.

The potential problem that may arise - often renewals provided the financial institution with the time to re-visit clients finances, allowing the opportunity to up and cross-sell products or consolidate debt into the mortgage (push a 20-year term back out to 25 for example).

While the new rules coming into effect are not going to affect renewals - they will end up affecting any mortgage which is re-written. this means it will greatly inhibit the financial institution's ability to rework clients debt, or for clients to consolidate larger consumer debt into their house.

What are your thoughts on this report?

Is it that this massive 47% of mortgages coming up for renewal over the year is a cause for concern or just business as usual?

Feel free to comment below.