Rate hikes could trigger a ‘correction or worse’ in the Canadian real estate market

The Bank of Canada’s all-time record low interest rates intended to stimulate economic activity at the height of the dire economic impacts of the COVID-19 pandemic may have worked too well.

Canadian households accumulated a huge amount of surplus savings during the pandemic, with a total value of about $300 billion. So households took advantage of the low rates and put at least part of their excess savings into buying real estate.

According to new analysis from BMO Economics, the high probability of upcoming rate hikes has forecasters saying all signs point to a downward trend in the real estate market in both demand and prices.

“We wouldn’t be at all surprised to see prices stabilize sometime next year. While there is room for discussion around the ‘lack of supply’ narrative, the recent price increase is driven by demand,” the analysis reads.

“Calls for a housing crash and a messy outcome for homes have been consistently wrong for over a decade, but the latest surge in home prices could make things different this time. Look for housing to cool in line with the pace of rate hikes. However, if policy rates rise above previous cycle highs, we would be in uncharted territory and could face a correction or worse.”

In the previous cycle between 2017 and 2019, when Bank of Canada policy rates jumped from 0.50% to 1.75%, the average household interest rate rose from 3.72% to 4.37%. If this rate goes back to 1.7% and changes the average household interest rate back to 4.37%, the additional interest cost will total about $27.

Between 2017 and 2018, the Bank of Canada increased its policy rate three times: 0.75%, 1%, 1.25%, 1.5%, and then 1.75%. This cycle of rate increases slowed down the rate of increase in house prices, along with new interventionist measures by governments through taxes to slow down the pace of demand. This pushed the annual increase in home prices from the double-digit percentages of teenagers to almost 0%.

In response to COVID-19, the Bank of Canada’s policy rate was lowered three times in March 2020: 1.25%, 0.75%, and then the all-time low of 0.25%.

On March 2, 2022, the Bank of Canada raised its benchmark rate to 0.5%, marking the first time the rate has been increased since 2018.

With more increases expected this year and possibly into 2023, BMO analysts say the potential for home price declines is greater this cycle as many cities have seen “prices go parabolic” recently. However, they add that for this reason, the Bank of Canada is not expected to overdo its rate hikes.

Home equity is currently at an all-time high of 76.5%, meaning that “anyone who purchased a home before the last previous period [in prices] you should have a decent amount of capital cushion if prices fall.”

Household indebtedness has increased in recent months, along with the housing boom. Since then, the debt-to-income ratio has returned to the highs of 2018-2019, now that the government’s pandemic support programs have ended.

“Over the last few decades, interest rates have been falling steadily. Policy rates have seen lower highs and lower lows, and the same can be said for term mortgage rates. All of that has led to a persistent increase in the debt burden of households.

“Warnings about the housing market and household debt will no doubt multiply in the coming weeks and months as the Bank of Canada raises rates.” But debt growth slowed in 2018 as interest rates rose, which is expected to repeat itself to some extent during the current cycle.

Earlier this year, a separate analysis by the UK-based international research group Oxford Economics issued a forecast that predicted a Canada house price drop of 24% between fall 2022 and summer 2024.

At the end of 2021, Canadian home prices were 19% above the borrowing capacity of middle-income households in Canada. And so far in 2022, this unsustainable upward trend has continued, with summer 2022 home prices expected to hit a level 38% higher than most borrowers can afford.

With all that said, strong and record immigration will be a constant source of housing demand, especially in the heated markets of British Columbia and Ontariothe main destinations of new immigrants.

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