BoC Overreach Poses Threat to Housing Market

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Benjamin Tal

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Benjamin Tal, deputy chief economist, CIBC.

So if you look at the overall situation, there are clear early signs that this same market, the housing market in Canada, is slowing down. And that’s a very good thing. Clearly, this is a market that is highly sensitive to higher interest rates, and interest rates are rising. They are rising, in fact, very, very quickly. So we have seen a situation in which the number of applications is starting to go down and originations of mortgages starting to slow down. We see more and more people still taking variable mortgage rates, but clearly they will shift to fixed rates soon, given the fact that variable rates are rising very, very quickly.

We have a situation in which the stress test is becoming a major issue, preventing people from actually getting the house that they want, and they are slowing down in their purchases. So this is a housing market that is slowing down, and that’s a very important trajectory because, as we all know, prices went up dramatically over the past two years.

Now, clearly we have a situation in which interest rates will continue to rise. And the key question for the housing market is how quickly and how high. And the Bank of Canada made it very clear that the interest rates will be rising very, very quickly, and they will reach about 2.5% in no time, probably by early 2023. This is a significant shock for the housing market, and we will see it first in the low-rise segment of the market, and we’re starting to see it also in the high-rise segment of the market.

The key risk that this market is facing is an overshooting by the Bank of Canada. Namely, I believe that if we go up quickly but stop at about 2.5, the market will adjust, but will not correct in a very significant way. If for some reason, the Bank of Canada continues to go to about 3.5% as the market is now pricing in, that can make a difference between an adjustment and actually a correction. This will increase the probability of a recession in 2023.

We know that the fundamentals of the market are very, very strong. We know that this market is under-supplied, but even an under-supplied market can correct in a recession. And that’s the risk that the market is facing. There is no question about the fact that the market will slow down. Sales might go down by 20, 25%. Also, the supply of available units will go down, and therefore the price will be protected. And we don’t see a significant decline in prices over the next year if rates stop at 2.5.

However, if the Bank of Canada continues to go aggressively to fight inflation, and inflation is a major issue, then the likelihood of a more significant correction is going to go higher and higher. That’s more or less where we are.

In this environment, I believe that you will see also some speculators in the market exiting the housing market, especially the condo space. We are starting to see it already. Many of those speculators are in negative cash flow, and now with interest rates rising, this negative cash flow is even deeper and leading to a situation in which some of those speculators will start selling, adding to the supply of the market. Now, this is something that we have to put in perspective. Not all investors are speculators. The opposite is the case. It’s only a small margin, but this margin, I believe, over the past year became a bit larger. And therefore, I see speculators exiting the market.

I am very bullish on the rental market. I think that the rental market will be very strong. Remember the value of homes relative to rent went up dramatically, and now we are seeing some catching up happening. So I’m very bullish on the rental market. I see increased demand for rental units and not enough supply.

Overall, what the government is trying to do for the first time is to improve supply, but this is something that will take a while. I believe that the government is very slow in moving on the supply side, but at least they admit that supply is the major issue. At the same time, the government is also trying to encourage first-time home buyers to get into the market vis-a-vis this tax-free saving account, and I suggest that this actually will have limited impact on the market because when you look at interest rates rising, the impact here is much more significant than what the government is providing you. And therefore, I don’t think that that will reverse the slowing in the market in any significant way.

So overall, look for interest rates to rise. They will rise very quickly. If they stop at 2.5%, I think the market will adjust, but not in a very significant way. It will slow down, but not a correction. If for some reason — and that’s a real possibility, with maybe a 30% probability — the Bank of Canada will overshoot, recession might come, and that actually will lead to a correction in the market.