Hikes may may “topple,” the housing market and lead to moderate price declines.Photo: karamysh / Adobe Stock

With the Bank of Canada having recently moved its target for the overnight rate to 0.5 per cent, more interest rate hikes are expected this year. One economist is warning that this may “topple,” the country’s housing market and lead to moderate price declines.

In a publication note, Stephen Brown, senior Canada economist with Capital Economics, said that the surge in interest rate expectations is “a key risk to housing.”

Due to a larger portion of variable rate mortgages compared to pre-pandemic times, Brown explained that the Bank of Canada would need to increase its policy rate to 2.5 per cent in order to achieve the same average mortgage rate on new borrowing as when the rate peaked at 1.75 per cent back in late 2018, which is what markets are now pricing in for 2023.

“​​The question, therefore, is can the housing market withstand a return to pre-pandemic mortgage rates, even though prices have risen by more than 50 per cent in the interim? The answer is a firm ‘no,’” said Brown in his note.

In a television interview with BNN Bloomberg, Brown said that 90 per cent of the mortgages before the pandemic were fixed-rate, but now almost 60 per cent of mortgages are variable-rate. In the past six months, fixed-rate mortgages have been hiked over 100 basis points, but this hasn’t done much to slow down the housing market as most people are now taking out variable mortgages, he explained.

“What really matters now is the extent to which the Bank tightens the policy rate, because that will feed through more or less one-on-one to the variable rate mortgages,” said Brown. “It does depend on the assumptions you use for what share of mortgages are variable- or fixed-rates, but I think sort of a broad number we can say that there’s probably going to be a hit to affordability in the range of 15 percent within just the next year or so from this point.”

The senior economist said that Capital Economics is forecasting that the policy rate will peak at two per cent, with the anticipation that housing price inflation will slow “to little more than zero next year.” If the policy rate were to go higher, this could set off a drop in home prices.

In the Bloomberg interview, Brown said that there could be a hit to affordability by at least 15 per cent and as high as 20 per cent. Assuming you are constrained by your mortgage payment, paying more interest would mean that the home price you could purchase may be lower in a year’s time.

“The question is can the housing market withstand a hit to affordability of 20 per cent, or simply as another way of looking at it, a return to pre-pandemic mortgage rates, even though we’ve had that surge in house prices in the interim?” said Brown. “I think it’s going to take a very optimistic view to say ‘Yes, that’s not going to cause any problems at all.’ I think at the very least, we’d expect to see some moderate house price declines,” he said.

Brown pointed out in his report that we “shouldn’t assume,” that the BoC wants to avoid house price declines. According to the most recent data from the Teranet–National Bank National Composite House Price Index (HPI), Canada recently reported its 20th consecutive month of property price growth.

As home prices are a “key driver of shelter inflation,” Brown said that moderate declines may help to control consumer price inflation without jeopardizing the economy.

“But with house prices now so elevated versus traditional valuation metrics, the risk is that an initial decline could trigger a downward spiral of lower house prices and lower house price expectations,” said Brown in his note.

Communities featured in this article

More articles like this