CIBC IS NOT GOING TO ZERO
2016-10-06 3pm EDT | #Canadian real estate #CIBC #bonds #CAD #oil
No need for me to tell you about the problem with Canada’s real estate market. We have all heard the stories about the epic bubble. For the past half of dozen years, every hedge fund under the sun has been shorting all things Canadian waiting for the bubble to burst and for the second coming of the great US real estate collapse to be ushered in. I have argued we would frustrate them with our Canadian “boringness,” and so far, that call hasn’t been all that wrong. Yet over the past year, the bubble has accelerated at an alarming rate. No longer was it simply the quaint Canadians with their rock steady real estate market, but instead Toronto, and most especially Vancouver, became magnets for Chinese money looking for a way to exit China. Suddenly Canadian real estate markets went parabolic as this extra demand pushed prices firmly into the stratosphere.
The problem came from the currency. The Chinese Yuan is loosely pegged to the US dollar, and as the Canadian dollar plunged on the back of the oil decline and the massive US dollar rally, the CNY appreciated against the loonie. This massive rally in CNYCAD made Canadian housing cheap for Chinese individuals. Combine that with Canada’s loose rules regarding foreign real estate ownership and suddenly there was no need to head to Macau to get your money out of China, Vancouver or Toronto was much better.
Canada prides itself in welcoming all sorts of immigrants. I wouldn’t want to change that one bit. But we were probably too tolerant of the foreign buying. It is one thing for immigrants to move to Canada to start a life in a new country, but quite another for our real estate market to be used as a way for capital to flee China. Now don’t get me wrong and think I am blaming the Chinese for our bubble, far from it. It is our fault. And don’t think Canadians didn’t get caught up in the speculation. But there can be no denying the usual Canadian boringness was thrown out the window by the sheer wall of money flowing from China.
It is kind of amusing to see all these hedge fund guys now taking what seems like victory laps on their negative Canadian real estate call. Have they not dialed a chart of the Canadian real estate price index? So far they have been dead wrong.
Yet I suspect the stopped clock is finally about to be right.
Earlier this week, the Canadian government introduced a series of regulations designed to take the air out of the Canadian real estate bubble. I won’t bother going through all the nitty details, but there are two important takeaways. The first is that house transactions will now have to be reported to the tax man, and to claim the capital gains exemption, individuals will have had to live in the house at the time of purchase. This is aimed at reducing the amount of tax free flipping occurring from foreigners. The second series of measures which will make credit more expensive. The Canadian government is hoping that by increasing the costs to banks and other financial institutions, the amount of easy money being funneled into real estate will cool.
The Canadian real estate market was already blown to a size due for a severe correction. Given these new regulations, the bubble has most likely being pricked. I suspect Prime Minister Trudeau’s liberal government might rue the day they decided to “fix” the problem. Many governments throughout history have been loathe to deal with bubbles as there is almost no upside. If they manage to simply cool an over heated market, no one notices. But if they cause a crash, they are blamed. Heads I win, tails you lose. The real solution is to never let a bubble be created in the first place, but that train has already left the station.
And the Canadian government is playing with fire. Real estate has been the lone shining star of the Canadian economy over the past few years. From the Globe and Mail:
The so-called economic rotation from oil to manufacturing exports that rate cuts (and the related decline in the Canadian dollar) were supposed to produce has not only failed to materialize but policy makers have pumped helium into an already overheated real estate sector that is masking structural weaknesses in the economy and setting us up for a bigger fall.
It’s “difficult to believe that any progress has been made in terms of economic rotation. Indeed, the opposite appears to be the case, given real estate’s increasingly large share of economic output,” TD Bank economist Brian DePratto noted in a Thursday report. “Rising home prices do have positive knock-on effects for consumer spending, but over-reliance on the real estate market is hardly the sign of a healthy economy.”
The real estate sector’s share of GDP has grown 0.4 percentage points in the past two years alone, TD noted, while the share of everything else (including oil and manufacturing) has shrunk. Going back 10 years, to May, 2006, manufacturing output is down 11 per cent in real terms and mining (including oil) extraction is flat. But real estate’s contribution to GDP has surged 35 per cent since then.
When you tack on to all those real estate fees the financial services that are bought and sold as part of real estate transactions, and the home renovations undertaken by prospective sellers or those unable to trade up to bigger or better houses as a result of surging prices, and it’s not going out on a limb to suggest that the sector has grown too big for the country’s own good.
For the first time during this whole Canadian real estate mania, I am willing to put on a trade based on the possibility it might be over. But how to play it? Most hedge funds are busy shorting the Canadian banks or other alternative lenders. That might work, but I doubt to the degree they are expecting. One famous trader turned newsletter writer has boasted about covering his short CIBC position at zero.
CIBC has a market cap of $30 billion US dollars. I am not sure of much in life, but I am willing to step ahead of my newsletter friend and say it will most likely bottom before zero (even if CIBC is, as we affectionately know it, the bank most likely to walk into a sharp stick.) Too many of these US hedge fund guys remember 2008 and assume it will be the same in Canada. Back then, Americans drove many of their banks to the brink of bankruptcy, so they expect the same will happen to Canadians.
I think a better bet is to assume the Canadian economy will underperform, but not implode into a 2008 style credit crash.
So how to structure a trade to take advantage of this view?
I am willing to bet rates in the US will rise much quicker than Canada.
As we enter a tightening cycle, Canadian rates might be dragged higher along with the US, but it will be slow. The spread between the short end of the Canadian and US curve has already flipped from Canada having higher rates to the US. This trend will only continue.
The other way to play the coming Canadian housing correction might be to short the Canadian dollar.
Unfortunately this is not quite so clean. There are a variety of factors that go into the pricing of currency rates. Recently there seems to be two major ones that are affecting the USDCAD rate. I stole this great chart from the Globe and Mail:
The USDCAD rate seems highly correlated with both the spread between short term interest rates, and the price of oil. You might even make the argument the oil price ultimately drives Canadian interest rates.
I am shorting Canadian dollars, but I am worried about the price of oil. I guess I am true Canadian, always expecting oil prices to rise. I understand all the arguments about the short term supply glut, yet I can’t help but worry that the best cure for low prices is low prices. Last year’s collapse in oil prices will cause a lot less wells being drilled. Over the long run, supply will shrink and prices will rise back to a higher equilibrium level. That equilibrium price is not $50. We can’t replace what we use at that level. Yet I don’t want to buy the front months of crude oil. I have no desire to play games predicting the next hurricane or the number of tankers sailing into Houston. I am buying far dated crude. The whole curve has collapsed and crude oil for delivery in December of 2020 is only $57. I think even the most bearish supply side worriers have to admit that in four years time, we will have worked off the excess inventory.
Bringing it back to Canadian real estate, the much anticipated correction has most likely already begun. I am long the short end of the Canadian yield curve versus short US. I am also shorting Canadian dollars, but with a small hedge in long dated crude oil. These are better ways to profit from a Canadian real estate slow down than waiting for CIBC to go to zero…
Thanks for reading,