Rob Chuter

What can we learn from the most recent numbers coming from the US? From the housing starts statistics we

learn that housing starts of single-family units are now at the lowest level seen in seventeen years. But the rate

of the decline is softening from 50% annualized rate to “only” 27%. But the more important message came

from single-family housing permits that are now rising for the first time in more than a year. And given that

permits lead residential construction by roughly six months, we might be seeing the light at the end of the

tunnel.

What’s more, it is very apparent that the market is already pricing in all this bad news and some. That’s why

we have not seen any reaction to the housing starts statistics and to the continued decline in house prices. In

fact, based on the mortgage default swap index, we can calculate that the market is pricing in overall

subprime-related losses of more than $500 billion—a significant amount that will probably end up being

higher than the actual tally. And that’s precisely the reason behind the fact that all major announcements

regarding subprime-related writedowns over the past six weeks were followed by winning days in the stock

market.

We also know that consumers are in a bad mood with the University of Michigan Consumer Sentiment Index

dropping 3.1 points in May. The index came in at 59.5, the lowest reading since June 1980. The decline from

April was larger for the current conditions component, although expectations also fell.

More importantly, inflation expectations continued to rise, especially short-term expectations. One-year

expectations increased to 5.2%, their highest level since 1982, from 4.8% in April. Five-year expectations rose

more modestly to 3.3% from April's 3.2%. The latter was the highest since 1996.

What does all this mean for the Fed? With conditions in the financial system starting to stabilize and some

indication of rising inflation expectations, the Fed will be much more guarded with regards to further monetary

easing. In fact, the market is not expecting the Fed to cut any more.

This also means that the Bank of Canada will be less willing to cut rates at the pace we have seen in the past

two months. While it’s possible that the Bank will cut one more time, the days of the current easing cycle are

numbered.

While we expect credit spreads to ease somewhat in the coming months, they probably will not return to precrisis

levels any time soon. For Canadian mortgage rates, it means that any future relief will be minimal and we

might see rates rising in 2009, as the Bank of Canada starts hiking rates and the bond market starts reacting to rising inflation.