Authored by Kevin Muir via The Macro Tourist blog,

“Do you mind if I have a pull?” the well dressed gentleman asked. The grandmother had been sitting at the dollar slot machine for over an hour. The tokens disappearing faster than when you drop a burger on the floor in front of your labrador retriever. Why not? She thought to herself, let him feed the bottomless pit for a bit. “Sure. Be my guest. But I warn you, it hasn’t been nice.” “Thanks. Awfully kind of you. I don’t know why, but I feel lucky tonight. All the machines are in use, so I appreciate you letting me play my hunch.” She watched the man remove a Bellagio one-dollar-token from his expensive suit and slip it in the slot. Then he pressed the button. The machine whirled and spit out the bad news. With a big smile, he took out another token and tried again. No luck. “One last time” he laughed as he pushed his final token into the slot machine. Then it happened. Instead of greeting him with bad news, the machine blazed WINNER! WINNER! WINNER! The man flashed a mischievous grin and said to the grandmother, “You have been playing this machine for a while. That’s your money. You take it.” “Oh no” she responded, “you were the lucky one. It wouldn’t have happened for me. I insist you keep your winnings.” “I tell you what. How about we take this money over to the craps table and try to turn it into some real dough? If we lose, so be it. If we win, we split it.” What the heck she thought to herself. I don’t get over to that side of the casino often. It might be fun. “Let’s do it” she said packing up her belongings. As the night progressed, she realized this man was indeed lucky. Somehow they kept winning at the craps table. And it was so much fun. He kept asking if she wanted to take her half and cash out. But she didn’t feel right taking his money. Besides, she didn’t want the evening to end. Why not let the fun continue until he inevitably loses it all? It will make a great story to tell the ladies in the bridge club. Another hour and a half later, she suddenly realized how long they had been playing. Sobering up, she had a good long hard look the big pile of chips in front of the gentleman and said, “What are those orange chips?” “Oh, you mean the pumpkins? Those are worth a $1,000” he told her. “And the red ones?” “Ahh… the cranberries? They’re 5k. And these little gems - they’re $25k” Holy smokes she thought to herself as she stared at the pile of chips. “Uhhhhhhh….” she stammered as she tried to estimate the value, “I think I’ll take my half now.” It turns out they had won well over half a million dollars. After counting it out, the man handed her stack of chips worth a little less than $300k and thanked her. As she was walking away, she said, “Peter, I never got your last name.” “Brown. Peter Brown. Nice to meet you.”

Little did that grandmother realize, but she had been playing craps with one of Vancouver’s most legendary financiers. From that chance encounter, that nice old grandmother took her winnings and put all of her grandkids through university. For the rest of her life, she never missed sending Peter a Christmas card.

Vancouver real estate

Some people are lucky enough to be born smart, while others are smart enough to be born lucky. Peter most likely falls into the latter camp but I suspect he got a healthy dose of both traits.

Although I love telling that story about Peter and the grandmother, it’s not his casino exploits I admire most, but his ability to ride bull markets and most importantly, get off without being left holding the bag. Now some of my Vancouver pals will tell me that Peter was notorious for selling their “promote” too early, but I don’t view that as a bad thing.

Which brings me to the topic of today’s discussion.

Peter owned a sprawling house in Vancouver’s tony Point Grey district. Of course he did. Peter didn’t do much at less than full speed. The house was almost 15,000 square feet with a little less than 2 acres of land.

But most importantly, it was in the city, yet boasted an incredible view of the harbour.

I am using the past tense when describing Peter’s house because he sold it. For $31 million. To a…(wait for it, this is the best part)… to a… student.

As usual Peter was a little early, but when you are trading size, you feed the ducks when they are quacking. And no doubt about it, in May of 2016 it was like a Ducks Unlimited convention in the Vancouver real estate market.

It’s starting to sink

Peter probably came as close to top-ticking the Vancouver real estate market as humanly possible. Although many charts will show you how prices continued to go up, these are the same indexes currently indicating only a modest downtick over the past half a year.

Talking to my buddies from Vancouver, it is obvious the market is soft. Really soft. There is way more going on than the charts indicate. Rich people often sit on their hands in real estate downturns, so it’s still unclear where the real bids are, but suffice it to say we have already had a decent correction in Vancouver housing prices. Especially at the top end. Like the kind of top end Peter used to own.

Why is that?

Well, there is tons of blame to go around so I don’t want to take sides, but let’s review the facts without judgment.

Canada, and Vancouver especially, opened its doors to Chinese immigrants. Rich Chinese citizens looking for a way to take some capital out of China found Canada an especially convenient route. And what better place to park it than real estate?

I have heard multiple stories of people selling their stately old homes in Shaughnessy or Point Grey only to rent them back from the Chinese numbered company that bought the house. The crazy part of their stories? The post-dated rent cheques were not being cashed. That’s the sort of stuff you see in bubbles. No doubt about it.

Housing prices kept rising. And rising. And rising. Stupid stuff like $31 million mansions being bought by Chinese students.

From a recent Bloomberg article:

Vancouver penthouses, ski chalets at Whistler, and holiday retreats in the Gulf Islands are among the thousands of properties identified in a dirty money probe that estimates more than C$7 billion ($5 billion) was laundered through the western Canadian province of British Columbia last year. The startling findings from two reports released by the provincial government Thursday illustrate how a torrent of suspicious cash has fueled casinos, luxury car sales and real estate in the Pacific Coast region. “The amount of money being laundered in B.C. is more than anyone predicted,” Finance Minister Carole James told reporters Thursday. In real estate alone, an estimated C$5 billion may have been laundered last year in the province – equivalent to 4.6% of all transactions by value in that period, according to one of the reports. In the Vancouver region, where housing prices rose more than 70% in five years, “I certainly believe that money laundering played a part,” James said. Such a share of transactions is “sufficiently large to have an observable impact on real estate prices,” the report said.

Finally the British Columbian government decided they had enough, and slapped down a foreign buyer tax. The shitty part of their stunt? They did not grandfather contracts that had been executed but not settled. So a Chinese buyer who had just plopped down $5 bucks on a Vancouver house suddenly found an extra three quarters of a million due on closing.

This occurred just as the Chinese economy was slowing down.

So when you combine the two developments, that iceberg bid that seemed unfillable disappeared almost overnight.

Then it really hit the fan

Last December, at the behest of American officials, a Chinese national was arrested in Vancouver. From the CBC:

The chief financial officer for Chinese telecom giant Huawei was detained at Vancouver International Airport on Dec. 1, 2018 at the behest of U.S. officials. The U.S. has accused Meng and Huawei of conspiracy, fraud and obstruction in relation to violating U.S. sanctions in Iran. On Wednesday, Meng’s team argued her arrest and detention were unlawful and that there is no basis for her extradition. Lawyer Scott Fenton said comments by U.S. President Donald Trump suggested the case against Meng was politically motivated. The U.S. and China have tried to keep Meng’s case separate from their trade dispute, although Trump has said he would consider intervening in the case if it would help forge a trade deal with Beijing.

Canada was simply complying with the extradition agreement we have in place with America, but for doing so, China has chosen to make an example out of us. They have scuttled merger deals (I believe the MEG Energy deal was ordered abandoned by Chinese authorities), refused to buy our commodities (check out the developments in the canola dispute) and in general, used every lever at their disposal to punish Canada.

What’s that line about acrimonious divorces? It’s always the children who suffer.

Well, Canada is definitely suffering in the feud between China and the U.S.

To think that it isn’t also affecting our real estate market is simply naive. Vancouver is the epicenter of Chinese capital-flight and that money is no longer coming to Canada.

And yes, the real estate correction that everyone has feared for so long in Canada is finally upon us.

Chinese students buying mega-mansions from Vancouver’s elite yet shrewd market-types peeling off their real estate holdings they have held for decades. What side of that trade do you want to be on?

The only question has been timing

I am by no means predicting the end of the world for Canada. We are after all a people who get by every year without a Canadian hockey team ever coming close to winning the Stanley Cup. We will soldier on.

Yet it would be naive to deny the long awaited real estate correction has started.

You don’t need to see more graphs about Canadian consumer indebtedness. We all know what they look like. The story is so well told it’s pointless to repeat any part of it.

A correction was coming, the only question left unanswered was timing.

Well, I think it’s now obvious that we are in the midst of that adjustment.

The only help I can offer is to point out that real estate cycles are long. Really long. The mistake will be assuming it will be over quickly. It won’t.

And my favourite trade?

I love buying the short end of the yield curve in Canada against selling the US equivalent tenor.

Probably the easiest way to play it is a long BAX DEC 2019 vs ED DEC 2019 spread:

Yeah, Canadian rates are already lower than in the United States. But the trend between the two countries is drifting nicely in the “right” direction. Again, no need to overthink it.

Sure, we have declined 50 basis points over the past year, but if we look at this spread over time, it’s far from unheard of for Canadian rates to be well below American rates.

Even more importantly, let’s examine what the market is pricing in for future Federal Reserve and Bank of Canada policy.

Up north, there is a minuscule 15 basis points of easing priced into the next two years.

This contrasts the US dollar denominated eurodollar futures market where there is 42 basis points of cutting in the curve.

As for the spread between 3-month US and Canadian short term rates, I am targeting 100 basis points discount in Canada over the next year. The forward futures for December 2019 are trading with a 48 basis point difference. It’s tough for me to devise a scenario where these two rates would trade back to even over the short to medium run, so on a risk-adjusted basis, I think it’s an attractive proposition. The market is overly worried about the American economy and much too sanguine about Canada’s prospects.

Yet as I write this Canada released the employment numbers for April. And they were stunningly strong.

I view this as a terrific opportunity to initiate my long BAX / short ED position. Maybe I am selling my home country short, but I just don’t see the Canadian economy outperforming the US in the coming year. Like our home based hockey teams, I expect it to disappoint.

Just remember, we knew eventually all those Canadian real estate owners would be like the grandmother playing with Peter Brown. At a certain point you look down at the stack of chips in front of you and decide, it’s time to cash out.