Harder housing correction possible following rate cut

TD Bank took swift action yesterday, becoming the first of the Big Six to decrease its prime-lending rate by 10 bps to 2.75% within an hour of the BoC cutting its key interest rate to 0.5%. The move was the opposite of earlier this year, when TD was the last of the major banks to reduce its rate in response to a BoC move.

Read: Experts split on rate cut’s impact

And now, CIBC, RBC, Scotiabank, BMO and National Bank have followed suit, slashing their rates to 2.7%. TD has further reduced its rate 5 bps to match.

Since mortgage lenders are offering lower rates, it’s cheaper for homebuyers to borrow money. And this could further fuel an already-heated housing market.

“In cities such as Toronto and Vancouver, where home prices are running ahead of income growth (detached markets mainly), it risks stretching valuations beyond what is supported by fundamentals,” says Robert Kavcic, senior economist, vice-president of Economic Research at
 BMO Capital Markets.

And if homes in these cities become more expensive, then “the odds of a harder correction go up,” he explains. That’s because demand will fade as many buyers get priced out of the market.

Read: BoC cuts rate to 0.5%

Phil Soper, president and CEO, Royal LePage, agrees, saying, “There will be upward pressure on prices in Toronto and Vancouver.” He’d warned on July 14 of a correction if the BoC cut its rate.

He adds, “A correction depends on how the market reacts.” On average, Canadian home prices increase annually at about 5%. “A 10% price increase, for instance, would be above the long-term norm, but it’s manageable. If we get 15% to 20% increases, that’s when you’re setting yourself up for a hard correction, which no one wants to see, as opposed to a gradual correction.”

And while markets like Atlantic Canada, Quebec and Alberta could benefit from demand, Soper notes that this rate cut won’t drive buyers. “The reason the market is tepid in those regions has to do with economic fundamentals—predominately employment,” he says. “I fear this cut in the Bank’s target rate won’t have a meaningful impact on demand in those regions. In other words, it won’t work where it’s needed.”

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Meanwhile, more borrowers who can’t get conventional loans might enter the subprime mortgage market.

“Where you might see a bit more activity due to lower rates is in the subprime space. [But these] borrowers are more sensitive to changes to interest rates,” says Benjamin Tal, deputy chief economist at CIBC World Markets Inc. “The move by the bank might accelerate activity exactly where you don’t want to see activity rising.”

BoC governor Stephen Poloz admitted in a press conference yesterday that the goal was to offer borrowers more choice. “When a consumer looks at what they have to pay for a mortgage, say a month or two months from now, they have a chance to look through various maturities. They can look at floating rates, or they can [ask for a discount at the bank]. People on floating rate mortgages get relief immediately, and we’ll see what they do with that.”

Still, Tal says, the cut’s impact on mortgage activity will be limited. “The impact on the five-year rate will be marginal. Given how low rates [already] are, the effectiveness of monetary easing is very limited when it comes to credit generation.”

And while nothing has been confirmed, the Financial Post reports the federal government is considering options, including a higher down payment requirement, to help cool the market.