Canadian real estate buyers are getting more irrational, says the world’s biggest central bank. The US Federal Reserve (The Fed) published its Q2 2021 exuberance index recently. The index, considered a “smoking gun” for bubbles, shows Canada is well into a real estate bubble. Researchers say markets that become exuberant will experience a correction in the future. The longer it takes to correct, the larger and more dangerous it becomes.
US Federal Reserve Exuberance Index
The US Federal Reserve Exuberance Index seeks to identify exuberant markets. It looks for “explosive dynamics” in prices, which is growth in excess of fundamentals. Exuberant price growth is considered irrational and based on emotion. Emotional buying is prone to rapid corrections which can become a threat to more than just one buyer.
One or two-quarters of exuberance isn’t an issue. It happens, but persistent exuberance is something that needs to be addressed. When buyers show persistent exuberance, the whole market is now considered exuberant. An exuberant market is better known as a bubble.
After the Great Recession, the Fed helped create the tool as an early bubble identifier. They call it their “smoking gun,” and is meant to help policymakers act on bubbles early. By addressing the issue early, countries can minimize the damage.
How do we use this tool? The index makes understanding market exuberance straightforward for analysts. They provide two sets of numbers, a country’s index and a 95% critical value threshold. If the quarter rises above the threshold it’s an exuberant quarter. After five consecutive quarters of exuberance, you have an exuberant market. That’s a bubble.
Canadian Home Buyers Are Becoming More Exuberant
Canadian real estate just logged another quarter as an exuberant market. The country’s housing printed 3.08 in Q2 2021, rising 0.06 points from the previous quarter. It’s now more than double the threshold value of 1.37 needed to be considered an exuberant quarter. This is the sixth consecutive quarter, meaning this is an exuberant market. Canadian real estate is now in a bubble, but it might be a lot worse than that just six quarters.
Canadian Real Estate Exuberance
The US Federal Reserve Exuberance Index score compared to the 95% critical value threshold. When the index rises above the threshold value, the quarter is considered exuberant. Five consecutive quarters of exuberance means the market is exuberant.
Source: US Federal Reserve; Better Dwelling.
Canadian Real Estate Might Be A Bubble On A Bubble
The Canadian real estate bubble is only six quarters old by this measure. As you can see above, it wasn’t very long since it was last an exuberant market though. Starting in Q2 2015, housing saw 14 consecutive quarters of exuberance. It spent a little time under the threshold starting in Q3 2018, spending 4 out of 5 quarters below the threshold. It isn’t enough time for a period to be considered non-exuberant. Additionally, the quarters under the threshold are barely under it.
Canadian real estate is either one longer bubble or a bubble on a bubble. If the bubble started in 2015, then Canada has been in a 25 quarter bubble, or 6.25 years. If the bubble is only six quarters, it’s a bubble on a bubble since it didn’t correct between. In either case, the gap between fundamentals and prices has expanded this whole time. The impact is essentially the same, meaning a larger correction is still needed.
The Fed says an exuberant real estate market will require a correction, though it can’t tell you when. Policy intervention to extend a bubble can delay a correction, making timelines unpredictable. Asset managers like Hilliard MacBeth warn this makes the issue worse. It’s essentially passing on a deficit of market inefficiency, meaning it has to be paid back later. With interest.