How Worrisome Is Canada’s Housing Market Warming Up Again?

Mortgage rates plunge in 2019 as bond market signals end of economic expansion

A sold sign in front of a west-end Toronto home in a file photo. Toronto homebuyers appear to be powering the national housing market while benefitting from lower mortgage rates. (The Canadian Press/Graeme Roy)

News Analysis

With the Canadian economy in decent shape, the housing market is perking up again. August’s sharp drop in interest rates will entice even more demand, though it’s coming at a time when the economic expansion could be ending, and if so, that would be problematic.

The red flag is that long-term interest rates have fallen below short-term interest rates—known as an inverted yield curve. This typically happens when investors start to worry about an economic slowdown and people become less confident in the future. It’s also a warning sign that a recession might be around the corner.

In the United States, the inverted yield curve phenomenon has preceded every recession since at least the 1960s, according to Bloomberg.

A recession would bring a higher chance of significant job loss, a drop in household spending (from already heavily indebted borrowers), and a collapse in the housing market. This is the worst-case sequence of events that policy-makers at the Bank of Canada and the International Monetary Fund have been sounding the alarm on for years.

Most of the time the yield curve is upward-sloping—with longer-term interest rates higher than short-term ones. This was the case in Canada after the 2008 financial crisis, when the BoC had cut rates aggressively and hopes about the future started to brighten. Mortgage rates were very low then too, but the upward-sloping yield curve signalled good days ahead for the economy and the housing market.

The phenomenon in Canada is different today. The 10-year Canadian bond yield as of Aug. 21 is 0.18 percent lower than the 2-year yield of 1.40 percent, and that difference has been getting more negative since late July. In addition, the average discounted 5-year fixed mortgage rate from the big banks has fallen by over 1 percent in 2019 to 3.02 percent.

August is one of the slower months in the mortgage business, but so far this month business has been bustling, says Robert McLister, founder of mortgage shopping site RateSpy.com.

The Canadian Real Estate Association reported on Aug. 15 that July home sales and prices are up nationally, led by Toronto and Vancouver—the culprits for the talk of a housing bubble—once again.

But what’s keeping the housing market from rising even faster is the big banks not lowering their posted 5-year mortgage rates, which factor into the federal mortgage stress test.

Big Banks’ Calculus

On the one hand, policy-makers are being criticized for the rigidity of the test, which aims to prevent prospective homebuyers from getting in over their heads. Conversely, economists and policy-makers are saying that this regulation, in particular, has set the housing market and the country’s household debt levels on a safer trajectory.

The stress test requires borrowers to qualify at a rate that’s the greater of 2 percent above their contract mortgage rate or the Bank of Canada’s 5-year mortgage rate—currently 5.19 percent—which is tied to the big banks’ posted 5-year rate.

“For housing to ramp up again, we need to see the benchmark 5-year posted rate drop materially,” McLister said. “But that would make mortgage regulators rather nervous.”

Competition in the mortgage space is heating up for the big banks. However, by maintaining an artificially high posted rate while offering much lower discounted rates, they can earn revenue from mortgage penalties when a borrower refinances at a lower rate, says McLister.

The big banks can also use a high posted rate to temper the amount of lending taking place if they believe a recession is in the cards.

First-Time Homebuyers

Soon to add to the housing market revival is the federal program to help qualified first-time homebuyers finance a portion of their home. Announced in the 2019 federal budget, the new initiative kicks off in September.

However, the timing of the program is now proving to be less than optimal, as housing affordability has been improving throughout 2019 as interest rates kept falling.

“Fundamentally, it’s probably beyond the point where we need it,” said BMO senior economist Robert Kavcic, adding that its impact on the housing market will be a rounding error.

“I don’t think it really addresses where the acute affordability problems are anyway,” he added.

Global Flu Symptoms

Canada’s relatively stable economic picture is being sullied by global weakness from Europe and the threat of the trade war intensifying between the United States and China.

Under such conditions, the demand for high-quality government bonds is driving up their prices, which pulls interest rates down.

Calls for the Bank of Canada to cut rates are mounting to keep pace with other central banks.

But Kavcic doesn’t think the BoC wants to cut rates quite yet—not until Canada’s economy is in a much worse situation. The rate cuts back in 2015 guided the economy through the oil price crash, but they also helped fuel the runaway house prices in Toronto and Vancouver.

“I think they’re pretty comfortable right now with the fact that the debt-to-income ratio has levelled off and credit growth has stabilized,” Kavcic said about the BoC and Canada’s indebted households. Household debt is growing roughly in line with incomes, at around 3.5 percent; however, he says it’s creeping up again due to the rebound in Toronto’s housing market.

Bloomberg reported on Aug. 18 that the average 30-year mortgage rate in the United States hit 3.6 percent—the lowest since November 2016—and total mortgage debt has risen to the highest level since the 2008 financial crisis. These are warning signs for Canada.

However, distress in financial markets and the global economy dating back to the financial crisis have not been as severe in Canada as in other parts of the world, including the United States. In Europe, for example, where Germany is facing a recession, interest rates have been negative for years in several countries.

Denmark’s third-largest lender, Jyske Bank, was reported to be offering a mortgage rate of -0.5 percent, where the bank would actually make mortgage payments to the borrower.