I’m fielding a ton of questions about whether the Bank of Canada will reignite a speculative bounce in home price inflation if it dares to cut interest rates. The short answer is “no.” Here are five reasons why.
First, the Bank of Canada would have to do a lot more than provide a few tweaks on interest rates to ameliorate the single biggest factor undermining housing demand: the super-stretched homeowner affordability ratio. Because of uber-inflated home prices and punishingly high interest rates, affordability is currently 50 per cent more stretched relative to the historical norm. The last time the affordability was this bad was in 1982 when interest rates were sitting at 14 per cent. We would need a 30-per-cent surge in personal incomes for the affordability ratio to revert to the mean, hardly likely now that the unemployment rate has climbed nearly a full percentage point from the most recent cycle’s lows (to 5.8 per cent). What about mortgage rates? They would have to drop 1.5 percentage points, all else equal, to normalize the severely strained affordability ratio.
Second, it’s not all about the cost of credit but also about the availability of credit. The banks are already pulling back on lending as the number of Canadian residential mortgages in arrears has jumped 11 per cent over the past year. As the loan-loss provisioning cycle accelerates, look for lenders to become much more circumspect on their credit-extension policies. As things stand, with the most recent data to the third quarter of 2023, the banks have, on net, been tightening non-price terms on residential mortgages for three quarters in a row. The year-over-year trend in mortgage lending has cooled off dramatically to a 3.4-per-cent increase (flat in volume terms), down from 8 per cent a year ago and is at its weakest pace since May, 2001. So, the Bank of Canada will need to cut rates hard to compensate for this increasingly constrained availability of mortgage credit if we are to enter a serious discussion of a return to accelerating home price inflation based just on rate cuts.
Third, there are the not-so-trivial issues surrounding the poor quality of Canadian household balance sheets. How can households think about leveraging up at a time when the overall debt-to-income ratio sits at a near-record 173 per-cent? At the credit bubble peak in the United States in the mid-2000s, the comparable ratio sat at 127 per cent (and by way of contrast, is now at 93 per cent – a stunning 80 percentage points below today’s Canadian household debt ratio.) This means that at the current level of interest rates, as of the third quarter of 2023, 15.2 per cent of Canadian personal incomes are now being siphoned into debt-servicing costs compared with 14.2 per cent the year before, attesting to the fact that Canadians are choking on their current debt burdens. To consider piling on even more leverage is almost unthinkable, no matter what the Bank of Canada does from here.
Consider for a moment that this is the most arduous debt-servicing ratio on record – even higher than in 1982 when interest rates were over 12 per cent, double today’s level. It is going to be exceedingly difficult to recreate a positive lending cycle, which is what would be required for a new phase of home price appreciation, at a time when delinquencies and defaults are going to be piling up.
Fourth – and this goes back to just how much the BoC would need to cut and attests to just how punishing the current interest rate level has become – the average effective interest rate for all consumer debt in Canada is now at a 22-year high of 6.7 per cent. At that time, the household debt ratio was less than 110 per cent, not north of 170 per cent as it is now, and so the ability to finance this debt load is far more difficult today than was the case back then. Today’s interest rate compares with 5.7 per cent this time last year and 2.7 per cent at the end of 2021. And this rate shock is a long way from being fully played out. Consider that the average interest rate over the past five years was 4 per cent, and there is a significant volume of loans still to reset to this reality (well over half, on our recent estimates).
My sense is that Canadians will be spending more time figuring out ways to stay current on their obligations rather than reloading the gun on a debt-financed real estate binge even with the Bank of Canada doing what it should in any event – responding to a decay in aggregate demand growth. That growth, by the way, is down to a microscopic pace of 0.5 per cent as of the third quarter of 2023, from 4 per cent the year before, and 4.8 per cent two years ago. You have to go back to the first quarter of 2021 to see the last time the Canadian economy was flat-lining like this – and, that’s when the bank’s policy rate was 0.25 per cent, not 5 per cent.
A fifth and final point here relates to the asset side of the Canadian household balance sheet. As it stands, Canadians are still massively overweight in residential real estate on their balance sheets. Residential real estate (structures and land) comprise 45 per cent of total household assets, which is nearly 10 percentage points above the historical norm and far above the 29-per-cent share in the United States. In fact, even at the housing bubble peak in 2005, U.S. residential real estate as a share of aggregate personal balance sheets never topped 34 per cent. And Canadians today are 11 percentage points above that U.S. peak that we can all agree today was a bubble of massive proportions. Not even the subsequent five-percentage-point plunge in policy rates and relentless rounds of quantitative easing could put Humpty Dumpty together again for at least a decade after that bubble popped.
To think that Canadians, because of any BoC policy moves, will end up unthink themselves to even more real estate on their bloated balance sheets is unfathomable – and it can only really happen if a bull market in irrational thought and irresponsible behaviour is in our future.
David Rosenberg is founder of Rosenberg Research, and author of the daily economic report, Breakfast with Dave.
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David Rosenberg