The Bank of Canada did the right thing and cut interest rates last week. But the question for investors now becomes how much more the bank will ease in this cycle, and how quickly.
In addition to the usual growth, inflation, and labour market considerations, we think the housing market will play a crucial role in future rate decisions. If the bank doesn’t ease fast enough, a looming mortgage renewal wall presents a very real risk of triggering an outright economic crisis.
Also see: Most economists think another BoC rate cut is coming in July. Markets aren’t as sure
The BoC needs to ease by far more than the 75 basis points priced in by next May to avoid this outcome. (There are 100 basis points in a percentage point.)
We recommend investors buy government of Canada bonds, and overweight the Toronto Stock Exchange sectors that benefit from sustained Canadian-dollar weakness. These include industries with a good export profile: auto manufacturers, transportation companies (continental transport firms price in U.S. dollars, and this sector also has tourism export exposure), and the entertainment industry (which exports production and location services). Canadian telecoms, which have strong pricing power and very high interest burdens, also tend to benefit when Canadian rates fall (alongside the loonie).
The key to determining how deeply the bank needs to cut interest rates, and how fast they can get there, will be determined by the housing market. Not house prices per se, but on mortgage market dynamics and how they interact with consumption and growth in the real economy.
Around half of existing mortgage holders are due to reset their mortgages by the end of 2026 – at much higher rates than the near-zero deals banks were offering in 2020/21. That’s a ticking time bomb for consumer discretionary income and consumption – the effect on consumer spending and asset prices could be enormous.
The bank faces a stark choice between adopting a reactive strategy (ease slowly; wait to see how bad things are when the mortgage wall is hit; clean up afterward) or a pro-active strategy (get rates low enough to minimize the damage before it’s done).
Fine-tuning a pre-emptive strategy would be difficult if inflation were a major risk, but with core inflation back to target, growth softening, and the BoC itself acknowledging that the economy is in a position of excess supply, there is a window of opportunity to normalize rates pro-actively with limited risk of kicking off inflation – especially when you remember that the lags from tight policy will still be hitting the economy for some time.
The risks of pursuing a reactive strategy far outweigh those of a pro-active one in our view. Logic and analysis will (hopefully) dictate that the bank arrives at the same conclusion.
Let’s tease out that logic a bit by looking at how mortgage dynamics affect the macro outlook. The central bank’s recently published 2024 Financial Stability Report enables us to update some of our estimates relating to the mortgages up for renewal. The numbers you need to keep top of mind are, first, that just under 50 per cent of the existing fixed-mortgage stock will be renewing by the end of 2026 (and 76 per cent of all categories of mortgages, including variable-rate mortgages with fixed payments, according to the Office of the Superintendent of Financial Institutions). Second, assuming rates stay where they are now, the average payment of a Canadian mortgage holder will double by the end of 2026 (and will be up to three times higher for renewing fixed-mortgage holders).
That’s a big shock, and it would hit the economy through three main channels:
• A pullback in consumer discretionary spending: If all of the mortgage holders due for renewal were simply to roll over at higher rates, Canadian consumer discretionary income available for spending on goods and services would shrink by 40 per cent. Even a shock of a quarter of that size would trigger a serious recession.
• A drawdown in excess savings: Unlike U.S. consumers, Canadians have held onto a large share of their pandemic-era savings (estimated at around $300-billion). Homeowners would be able to limit mortgage payments by sinking these savings into home equity. But that would also mean a large drawdown on investment portfolios (in turn hitting asset prices), and less room to deploy savings for spending on items such as cars and vacations.
• Housing supply released onto the market: Unfortunately, higher rates will force some homeowners to downsize or return to the rental market. That will release supply onto the market, helping to offset demand effects from lower rates and limiting the risk of a resumption of the house price bubble. If this effect is large enough, house prices could fall, hurting confidence and imposing a negative wealth effect.
The size of the impact of these channels will depend on how fast rates come down. The slower the BoC normalizes, the bigger all three of these contractionary effects will be, with the “tail risk” for the economy being a full-blown housing-market-centered economic crash.
Look at the cracks already showing in the system. The banks are aware of the risks; they’re tightening access to mortgage credit through non-price channels (credit scores, down payments), they’re no longer “terming out” mortgages to 35-plus years, and they’ve increased their loan-loss provisions. Arrears on mortgage lending are rising rapidly (from an admittedly low base). That will only get worse as consumers are already staring down the highest mortgage debt service ratio this century and the worst housing affordability ratio in nearly 40 years.
The BoC needs to reduce rates fast enough to avoid making a policy mistake that results in a deep recession. But even setting mortgage dynamics aside, there is a strong case for rates to go back to neutral sooner rather than later. Growth is flagging, investment is far too low to raise future growth prospects, a negative output gap is setting a broadly disinflationary backdrop, and labour supply growth is easily outstripping employment growth.
The economy needs relief from tight policy. Taking everything together, there is a strong case for an assertive, pro-active approach to easing policy. At just 75 basis points of cuts over the next 12 months (which would still leave policy restrictive at 4.0 per cent compared to the BoC’s neutral-rate estimate of 2.25 to 3.25 per cent), we don’t think markets have gone far enough in pricing the easing cycle.
Dylan Smith is senior economist at Rosenberg Research
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