If you want a real-life definition of “pushing on a string,” look no further than the Bank of Canada. Despite all the efforts to kickstart growth through aggressive rate cuts these past few years, a poll of 1,501 non-homeowner Canadians by personal finance platform NerdWallet showed more than half of them stating that they have zero intention of buying a house over the coming year.
One in three cannot afford to make a down payment, which means that if the BoC stays on the sidelines or dares to raise rates, home prices need to deflate further to revert to the mean what is clearly a strained affordability ratio — about 20 per cent more stretched than the average of the past 25 years, despite the Bank’s heavy lifting and the correction in nationwide home values. Especially for the 18-34 age cohort, homeownership is still far out of reach.
The thing is, if home prices continue to deflate, the pressure will be on the central bank to kickstart its easing campaign, which is why we have a core holding in our model portfolio at the front end of the GoC bond curve. (These shorter-term bonds are particularly sensitive to changes in the bank’s policy rate, so a rate cut would pressure yields lower and prices – which move inversely – higher.)
The other issue is that the average five-year mortgage rate of 5.13 per cent has not budged in the past 12 months. In fact, it is up a little. The BoC only controls the overnight rate — the mortgage market is priced off the bond market, and the Canadian bond market is hitched to the U.S. Treasury market, where yields have backed up 50 basis points over the past three months.
The problem of compounding even low interest rates against a mountain of liabilities (the household debt/income ratio is in the stratosphere at 166 per cent — 35 percentage points higher than the U.S. pre-crisis peak in 2007 — and has left the Canadian household debt-service/income ratio near record highs of 14.75 per cent. This is measurably higher than in the early 1990s when interest rates were in double-digit territory (the median loan-to-income ratio for first-time buyers has approached a record 365 per cent; and a record one-in-five have a ratio of more than 450 per cent).
As the BoC frets about an exogenous cost-push inflation shock, the number of Canadian personal bankruptcies has soared more than 10 per cent in the past year to a level (nearly 3,000) we last saw at the peak of the pandemic anxiety in March, 2020 — and there is nothing inflationary about that stress statistic.
Like everyone, we have marveled at the performance of the Canadian bank stocks over the past year. But it is an open question as to what it would mean if home prices continue to deflate, which would seem to be a logical conclusion from the fact that the homeowner affordability remains so far beyond the norm. The banks collectively hold a record $1.7-trillion of residential mortgages on their balance sheets, which represents nearly half of their total loan book.
A prolonged cycle of residential real estate deflation and the delinquency cycle that would ensue could be the catalyst for a reversal in this amazing bull run in the banking sector’s valuations.
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Suffice it to say, there are no grounds for the BoC to hike rates. We believe the odds still favour the next move, whenever it comes, to be a cut. With the Fed sounding more bellicose by the day, the expected widening in those negative interest rate spreads between Canada and the U.S. (-140 basis points for 2-year bonds) will ensure that the Canadian dollar remains on its weakening path. And we are talking about the potential for a move to, or even less than, 65 US cents (from just over 70 cents currently).
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Not unprecedented, mind you — we were last there nearly a quarter of a century ago. This doesn’t even account for what happens if U.S. President Donald Trump and his trade team end up deciding to walk away from the USMCA, with clear negative implications for the domestic business capex outlook.
David Rosenberg is founder of Rosenberg Research.
