Income Strategy July 27, 2007:

The US housing sales continue to slow with new home sales down another 6.6% to 834,000 in June nearly touching a 7 year low.  New home sales are now 22% lower than a year ago and decline in new home sales appears to a considerable amount to go. The inventory of unsold homes is approaching a new all time high of 7.8 months sales.

Existing home sales were down 3.9% to 5.75 million a 5 year low and are now down 11% from a year ago. Interestingly existing home prices were unchanged from the previous month while new home prices were down by 2.2%.

The situation in the housing market is likely to get considerably worst before it gets better; the number of homes in foreclosure is increasing dramatically each week adding to the potential selling pressure. Borrowers who were enticed into borrowing to the max and beyond by with a low initial rate for the first year or two are now having their mortgage rate  reset and they can’t afford the new payment and are being forced into foreclosure as a result.

This deterioration in the housing sector is going to ha e a negative impact on the credit markets generally and is likely to cause a long term flight to quality in the bond market as investor try to reduce risk. Collateralized Debt Obligations (CDOs) are going to get hammered as the price of the collateral, homes, falls due to heavy and consistent selling by owners and financial institutions.

The damage to the US economy has only just begun and all bonds are going to decline in price as investors demand higher yields as perception and reality of risk comes back to the market, liquidity is drying up and there will be an over correction as a reaction to risk being ignored for such an extended period of time.

To the surprise of many investors the Canadian dollar continues to move higher verses the US dollar. These investors have tended to focus on the wrong side of the equation, the Canadian dollar has not been overly strong but the US dollar has been materially weak.

The US economy has been performing quite well over the past few months but the currency has been taking it on the chin. The recent revelation regarding the potential size of the problem in the sub-prime lending market, which the Federal Reserve now estimates could be between $50 and $100 billion, has created a realization that there is risk in these markets and investors have reacted by selling US dollar investments and moving to diversify into other currencies to reduce risk. The increased attention to risk will likely mean lower prices in many markets.

The weak US dollar is creating a lot of uncertainty globally, with so many commodities priced in US dollars consumers all over the world are benefiting with lower prices but producers are feeling the price change on the bottom line. Canadian commodity producers will not see the same strong gains over the next year or so as the US dollar continues to fall. On the bright side the greenbacks decline will help to restrain the upward pressure on inflation. Imported goods from China will become even less expensive in Canadian dollar terms which should help to slow the rise in core inflation over the near term.

The main economic change that will be taking place in North America is a more pronounced decoupling between the US and Canadian economies. The US will see much higher inflation rates over the next year or so as energy prices appear to have the potential to remain near current levels possibly higher, food inflation will be driven by the increases in all of the basic foods due to a surge in grain prices as ethanol takes a larger portion of the corn crop going forward and imported goods other than those produced in China will become more expensive as well. This will likely inspire some members of the house and senate into enacting legislation to penalize Chinese imports, which will ultimately penalize the US consumer and add inflation pressure.

In contrast the Canadian economy will likely see an easing in inflation as the Canadian dollar will make imports less expensive and energy prices have the potential to stabilize or decline in Canadian dollar terms. Food inflation will not likely be as severe due to a stronger currency making fresh fruits and vegetables imported from the US less expensive.