Skip to main content

As the Bank of Canada continues tightening monetary policy in the coming months, the Canadian economy will have to confront the reality that its unsustainable household debt load will act as a constraint on economic growth. And this will be at a time when the housing sector, which had been boosted by investor speculation throughout the COVID-19 pandemic, is set to crumble.

All this suggests consumers will be further sent into a state of distress.

All in, these developments will likely ensure a premature end to the central bank’s tightening phase as the realization that recession is imminent sets in.

Prior to the COVID-19 pandemic, Canada already had some of the highest levels of household debt relative to its global peers – with a household debt-to-GDP ratio of 102 per cent in the final quarter of 2019, compared with 74 per cent in the United States. And while it’s true that rock bottom interest rates fuelled debt bulges on both sides of the border, Canada’s debt levels relative to GDP soared at a much quicker rate, leading to a 37 percentage point difference with our U.S. counterpart as of the second quarter of 2020 – the largest gap in recorded history.

In large part, the runup in Canadian debt levels can be traced to the near-vertical uptick in home prices, which in turn fuelled demand for riskier and riskier mortgages as this speculative frenzy encouraged households to load up on leverage in order to participate in the bubbly real estate market. Indeed, household mortgages in Canada have shot up at nearly a 9-per-cent annual rate since the beginning of the pandemic and, among borrowers, the level of high-risk homeowners (those with a loan-to-income ratio above 4.5 times) has reached a new peak of roughly 27 per cent.

And while historically low interest rates have meant that the debt service ratio (a measure of how much income is required to pay off debt) has been kept to manageable levels, the interest rate hiking cycle will send this ratio upward, shocking the household sector that loaded up on “cheap” debt (at the time) in the process.

So, the effect of rising debt servicing costs is that the consumers will ultimately be forced to make room in the budget to pay off debt at the expense of broader spending – which will hinder GDP growth. Debt levels and economic growth prospects have a negative relationship.

Based on just the lofty levels of household debt alone, one can reasonably argue that the Canadian economy is in a fragile state. But throw in the fact that the beloved real estate market is vulnerable to a collapse at any moment and the problem becomes even more acute. Clearly, the housing bubble and Canadian debt bulge are inextricably linked – rising home prices contributed to a runup in debt, and any housing market crash would have a greater impact on the economy as consumers confront a negative wealth shock while hysteria pertaining to their overloaded balance sheets sets in.

And while it seems logical to argue that rising interest rates should halt home price growth, the history books don’t show this to be true in practice. So, the key question then becomes, why is this time different? Well, the answer lies within the nature of the current bubble: We have never seen a speculative frenzy such as the one witnessed throughout the COVID-19 pandemic. Indeed, much of the runup in home prices was fuelled by investors rather than first-time and repeat homebuyers – the share of investor purchases rose from 19 per cent two years ago to 22 per cent today. And, crucially, investors are the most interest-sensitive buyer group, owing to their profit motivation and higher levels of indebtedness compared with other buyer types. So higher interest rates could very well prompt a pullback in demand from this key segment of demand.

And not only that, but homebuyers are particularly vulnerable because they opted for variable rate mortgages with longer amortization periods.

So, it comes as no surprise that perhaps the most rates-sensitive housing market of all time has already taken a hit – the decay is evident in Canada’s two largest real estate markets, Toronto and Vancouver, where home prices have started their descent. And there’s more damage to come.

The key takeaway is that the Canadian economy is in a much more fragile state than the central bank realizes. The unsustainable levels of household debt will not only hinder future economic growth but will also ensure that the upcoming recession will be far more disastrous than many believe – especially since the speculative housing market looks set for a monstrous fall-off.

We did the math, and the combined effect of the direct rate shock on debt-service costs and the house price channel comes to a drag of one percentage point on real GDP growth this year and the negative impact builds to minus 2.5 percentage points in 2023.

Given the baseline growth-line – the underlying trend – of between 2 per cent and 3 per cent, escaping a recession in the coming year will be a very tall order if, indeed, the Bank of Canada turns out to be as aggressive as the futures market indicates.

As such, the 75-basis point hike the market has priced in for the next policy rate meeting in September is overly aggressive, in our view. All in, these developments do not bode well for the loonie.

David Rosenberg is founder of Rosenberg Research, and author of the daily economic report, Breakfast with Dave. Julia Wendling is an economist with the firm.

Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.