Rate hikes could cause Canadian housing market "correction or worse"

Single-family home (Nature's Charm/Shutterstock)

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

Canadian households accumulated a massive amount of excess savings during the pandemic, worth about $300 billion in total. Households then took advantage of low rates and directed at least a part of their excess savings towards buying real estate.

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The high likelihood of forthcoming rate hikes now have the forecasters stating all signs point towards a downward trend in the housing market in both demand and prices, according to a new analysis by BMO Economics.

“We wouldn’t be at all surprised to see prices flatten out at some point next year. While there’s room for discussion around the ‘lack of supply’ narrative, the recent surge in prices is demand-driven,” reads the analysis.

“The calls for a housing crash and disorderly outcome for households 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 climb above prior cycle highs, we’d be in uncharted territory and could be in for 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 returns to 1.7% and shifts the average household interest rate back to 4.37%, the additional interest cost will total about $27.

Between 2017 and 2018, Bank of Canada increased its policy rate three times — 0.75%, 1%, 1.25%, 1.5%, and then 1.75%. This rate increase cycle dampened the pace of home price increases, 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 high teens double-digit percentages to almost 0%.

In response to COVID-19, the policy rate of Bank of Canada went down three times in March 2020 — 1.25%, 0.75%, and then the historic low of 0.25%.

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

With more increases expected this year and possibly into 2023, analysts with BMO state the potential for home price declines is higher 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 increases.

Homeowner equity is currently at a record high of 76.5%, which means “anyone who bought a home before the latest run-up [in prices] should have a decent amount of equity cushion if prices drop.”

Household debt has risen in recent months, alongside the housing boom. The debt-to-income ratio has since returned to the highs of 2018-2019, now that pandemic government support programs have ended.

“Over the past few decades, interest rates have been falling consistently. Policy rates have seen lower highs and lower lows, and the same can be said about term mortgage rates. All of that has led to persistently rising household debt burdens,” continues the BMO Economics analysis.

“The warnings on the housing market and household debt will no doubt multiply in the weeks and months ahead as the Bank of Canada pushes rates higher.” But debt growth slowed in 2018 when interest rates increased, which is expected to repeat to an extent for the current cycle.

Earlier this year, a separate analysis by UK-based international research group Oxford Economics issued a forecast that predicted a Canadian home 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 median-income households in Canada. And so far in 2022, this upward unsustainable trend has continued, with home prices by Summer 2022 expected to reach a level that is 38% higher than what most borrowers can afford.

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

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