Home » Market Watch » How Would Higher Interest Rates Affect Canada?

How Would Higher Interest Rates Affect Canada?

Canada is currently experiencing the lowest interest rate environment since July of 1958 when the Bank of Canada’s policy rate was lowered to 1.22%. The catalyst for the current unprecedented loose monetary policy is the great recession of 2008. Fast forward four years later and what are the consequences to the Canadian economy? This sustained and significantly low interest rate environment has resulted in significant price appreciation in real estate and record levels in household debt.

The Bank of Montreal has recently released its Housing Confidence Report and the findings are summarized below. The survey sample consisted of 1,011 random Canadian homeowners and was conducted through online interviews.

The key takeaways from the report are as follows:

  • 17% of respondents have dipped into their savings in order to meet mortgage payments
  • 72% of respondents stated that they would be under significant financial strain even if mortgage payments were to increase slightly
  • 33% of respondents have already cut back on their spending
  • 16% of respondents said that they would be at risk of not being able to afford their home if mortgage payments were to rise by 10%
  • 46% of respondents plan on buying a home in the next five years, but buying interest will decline to 36% if home prices were to increase by 5%
  • 22% of respondents will not buy a new home in the next five years due to the new mortgage rules
  • 29% of respondents will spend less money on a home due to the new mortgage rules
  • 10% of respondents plan on selling their current home and relocating to a family member’s home, retirement home or a rental property

It is clear from the answers above that demand and affordability of Canadian real estate is very sensitive to future increases in borrowing costs. The respondents’ answers are subsequent to the new mortgage rules which were in effect as of July 9th of this year and it appears that the Government’s initiative to slow down Canada’s red hot real estate market is exhibiting signs of success. The Bank of Canada’s policy rate of 1% has resulted in significant real estate price appreciation; unfortunately, a commensurate increase in Canadian household debt has also materialized. In fact, Canadian household debt is currently at 163% of income which is around the same level as the United States before their housing market popped in 2007-2008. Although the debt level in and of itself is high, it does not mean Canada will suffer a U.S. style housing meltdown; the quality of debt between the two countries is dissimilar (the United States’ debt problem was much worst due to the amount of outstanding sub-prime mortgages) and because Canadians on average have more equity in their houses compared to their U.S. counterpart.

There are many different scenarios that can play out for the future of Canada, but examining the two extremes will provide perspective. One scenario is that Canada experiences a soft landing where interest rates eventually rise in an orderly, modest and controlled manner. It is imperative that the magnitude and speed of interest rate changes be undertaken prudently because of the sensitivity of real estate values to borrowing costs. The Bank of Canada has estimated that 40% of Canadian household net worth is tied to the value of real estate holdings; therefore, the situation is even more fragile. The ideal situation is a steady increase in rates which will help further cool down the Canadian real estate market in such a way that does not incite widespread panic, but brings prices back down to fundamental values in a steady manner. This mild uptrend in borrowing costs will also help normalize the demand for credit and aid in the household debt problem Canada is currently facing.

The second scenario is for Canada to encounter a hard landing. This will most likely come into fruition if the Central Bank mishandles its monetary policy and tightens up too quickly and by too much. Although this scenario is likely a low probability event, it would be important to understand the ramifications if such a scenario were to play out. First of all the demand for consumer level credit will decrease which also lowers the demand for goods and services. This will have the effect of lowering corporate profits and negatively impacting the employment situation as companies look to reduce their expenses. In addition, commercial level demand for credit will decline commensurately as construction projects and business expansions for example are put on hold; the increase in the cost of capital makes financing these projects more expensive and may negatively affect the economics of moving forward with them.

Rate increases will lower the demand of real estate as borrowing costs rise which will directly lead to an increase of supply for sale. This imbalance in supply and demand will result in price declines and the magnitude of this decline is contingent on the psychology of the market. Just as behavioral weaknesses such as confirmation bias, herd mentality and positive feedback investing reinforces and supports price trends on the upside, they will have a similar effect on the downside. Let’s look at the factors that will determine to what degree the severity of the market’s psychology can change: 40% of Canadian net worth is tied to real estate value; therefore, a portion of owners will want to divest their real estate holdings in order to preserve wealth if they think the market is correcting; real estate is an illiquid asset which may magnify price declines as sellers lower their offers in desperation for liquidity; current real estate owners are most likely sitting on significant paper profits earned over many years and will want to realize these returns before the market takes it away, and finally if real estate holders experience the “lemming effect” where they use trends in price and herding behavior from others as feedback to guide their own decision making. In summary, rate increases may provide the catalyst for a real estate correction and change in trend. Market psychology such as fear and expectation of future lower prices will further exacerbate this trend to the downside. Ultimately, the decline will continue until fundamental values diverge enough to attract “smart money” investors.

It is impossible to know when a market correction will occur; however, there is one thing that can be known for sure: no market goes up in perpetuity. Now, Canadian real estate has been increasing for approximately the last 12 years and sometimes the situation just requires common sense. What is the probability of a sustained price increase versus the probability of a price correction? I’m sure you all know the answer.

Check Also

Market Watch – January 2019

TORONTO, February 6, 2019 – TREB President Garry Bhaura announced that Greater Toronto Area REALTORS® …

2 comments

  1. Royce! Very insightful post!

    Get in touch with me, I’d like to chat. You can find my contact details at dipettamortgage.com

Say something here