Today’s Financial Stability Report from the Bank of Canada suggests that, on the whole, vulnerabilities in the financial system have intensified, raising the probability of a housing-induced recession.
The key risk the bank highlighted was that more households are now “carrying high levels of mortgage debt.” As a result, the Bank’s current monetary policy stance, which favours higher interest rates to slow the pace of inflation, will have a larger and more rapid effect on the economy, as they will more quickly see higher debt servicing costs that crowd out other spending. The Bank added that although household assets rose during the pandemic, the distribution of that increase was uneven, with the most indebted households seeing the smallest gains, which intensifies that risk.
The Bank of Canada’s list of key vulnerabilities in the financial system is broadly unchanged from last year, but most vulnerabilities have intensified
Furthermore, the Bank emphasised that a house price correction would have the largest impact on households who bought homes in the “last year or so,” as they have built less home equity and wealth than most homeowners.
As a result, those households will likely see a larger negative wealth effect on their saving and spending decisions should a significant house price correction materialise. The Bank’s emphasis on these risks bolsters the case for our key call for the Canadian economy and the Canadian dollar: we think that the risks of a housing downturn could act as a handbrake on the BoC’s hiking cycle, leading to a slowing in the current 50bp hiking pace and a potential pause in the second half of 2022 as rates enter the Bank’s estimated neutral range. This would be a dovish divergence from current market pricing, and as result, markets could reprice Canadian bond yields lower and induce a depreciation in the loonie. Note that our view is in sharp contrast to the Bank’s professed intentions: Governor Macklem said in the press conference that the probability of rates reaching to the top of the 2 to 3 percent neutral range, or even beyond, has risen.
In response to a question asking whether the Bank would consider pausing its hiking cycle in the event of a significant house price correction, Macklem played down the possibility. Nevertheless, his response to that question was less confident, fluid, and well-reasoned than his other answers in the press conference, which raises our conviction in our call. Macklem argued that household balance sheets have strengthened on average, which is true.
Despite the increase in household indebtedness, Canadians have indeed accumulated excess savings that, on average, appear to offset the risk of higher financing costs.
Despite this, the extreme levels of leverage, which previously limited the extent of the Bank’s last hiking cycle, are likely to prompt the BoC into a more cautious policy stance once rates begin to enter the neutral range.
Macklem’s argument about household financial resilience increasing on average ignores the disparate effects on various segments of the Canadian population, which was the point emphasised within the housing section of the report. Just because most Canadians have sufficiently strong balance sheets to resist a house price correction does not mean that the excess savings accumulated by some people will offset the high level of debt to assets for other people—they are entirely different groups of people, as the Bank itself mentioned in the report.
Without some form of targeted fiscal policy to serve as a backstop for the most financially vulnerable people, a policy-induced correction would create severe economic pain for those individuals. We don’t think the Bank is genuinely willing to pursue a policy that has a severe negative impact on a major sub-section of the Canadian population, as it would contradict their previous policy goal of creating an “inclusive” economic recovery from the Covid recession.
While this doesn’t necessarily mean a housing downturn will cause an end to the hiking cycle, in our view, it does suggest a more data-driven reaction function that should see the Bank more willing to pause or take more measured steps of 25bp increments as they look to see whether, and if so how badly, the downward trend worsens.
After talking down housing risk, Macklem pivoted back to the inflation mandate, emphasising that the Bank is trying to cool inflation by raising rates to get rid of excess domestic demand, while hoping that longer-term inflation expectations will stay sufficiently well-anchored that inflation will normalise once external inflation conditions abate. The problem with this stance is that, although it is a plausible scenario for the economy, it is premised on hope. And as the late comedian Norm Macdonald once joked, “[I don’t care] what Obama says, hope is never good. Don’t try it, it never works out.” Much needs to go right for the Bank to achieve its forecasted cooling of inflation on top of a soft landing. We think our view is more realistic, considering the rapid degree of tightening in financial conditions that has well out-paced the small change thus far in the Bank’s policy rate.
Despite the reaffirmation that higher rates are needed, Canadian bond yields have bucked the trend in US Treasuries and European government bonds by bull steepening– front-end CGB yields are trading 3.7bps lower on the day, while the 10-year yield is only 1.9bps lower.
Coupled with a downturn in North American indices and a slight moderation in WTI spot prices, the broader market backdrop is considered the perfect storm for CAD depreciation ahead of tomorrow’s Labour Force Survey data.
Short-term mortgage debt makes up the second-largest category of household debt
Most of the increase in household debt over the past year has been in mortgages that are either variable rate or must be renewed in under 1 year
Simon Harvey, Head of FX Analysis
Jay Zhao-Murray, FX Market Analysis