The Bank of Canada did the right thing and cut interest rates at Wednesday’s meeting. But there is no rest for the wicked, and the question for investors now becomes how much more the bank will ease in this cycle, and how quickly.
In addition to the usual growth, inflation, and labour market considerations, we think the housing market will play a crucial role in upcoming rate decisions. If the bank doesn’t ease fast enough, a looming mortgage renewal wall presents a very real risk of triggering an outright economic crisis.
Also see: Most economists think another BoC rate cut is coming in July. Markets aren’t as sure
Tiff & Co. need to ease by far more than the 75 basis points priced in by next May to avoid this outcome. Buy government of Canada bonds, and overweight the TSX sectors that benefit from sustained Canadian dollar weakness. These include industries with a good export profile: auto manufacturers, transportation companies (continental transport firms price in U.S. dollars, and this sector has tourism export exposure too), and the entertainment industry (which exports production and location services). Canadian telecoms, which have strong pricing power and very high interest burdens, also tend to benefit when Canadian rates fall (alongside the loonie).
The key to determining how deeply the Bank of Canada needs to cut interest rates, and how fast they can get there, will be determined to no small degree by the housing market. Not house prices per se, but on mortgage market dynamics and how they interact with consumption and growth in the real economy.
Around half of existing mortgage holders are due to reset their mortgages by the end of 2026 — at much higher rates than the near-zero deals banks were offering in 2020/21. That’s a ticking time bomb for consumer discretionary income and consumption — the effect on consumer spending and asset prices could be enormous. The bank faces a stark choice between adopting a reactive strategy (ease slowly; wait to see how bad things are when the mortgage wall is hit; clean up afterwards) or a proactive strategy (get rates low enough to minimize the damage before it’s done). Fine-tuning a preemptive strategy would be difficult if inflation were a major risk, but with core inflation back to target, growth softening, and the BoC itself acknowledging that the economy is in a position of excess supply, there is a window of opportunity to normalize rates proactively with limited risk of kicking off inflation — especially when you remember that the lags from tight policy will still be hitting the economy for some time.
The risks of pursuing a reactive strategy far outweigh those of a proactive one, in our view. Logic and analysis will (hopefully) dictate that the Bank arrives at the same conclusion.
Let’s tease out that logic a bit by looking at how mortgage dynamics affect the macro outlook. The recently published 2024 Financial Stability Report enables us to update some of our estimates relating to the mortgages up for renewal. The numbers you need to keep top of mind are, first, that just under 50% of the existing fixed mortgage stock will be renewing by the end of 2026 (and 76% of all categories of mortgages, including variable rate mortgages with fixed payments, per OSFI). Second, assuming rates stay where they are now, the average payment of a Canadian mortgage holder will face double the mortgage payment by the end of 2026 compared to current levels (and up to 3x for renewing fixed mortgage holders).
Half the mortgage market, twice the average payment going to interest instead of consumer spending. That’s a big shock, and it would hit the economy through three main channels:
• A pullback in consumer discretionary spending: If all of the mortgage holders due for renewal were simply to roll over at higher rates, Canadian consumer discretionary income available for spending on goods and services would shrink by 40%. Even a shock of a quarter of that size would trigger a serious recession.
• A drawdown in excess savings: Unlike U.S. consumers, Canadians have held onto a large share of their pandemic-era savings (estimated at around C$300 billion). Homeowners would be able to limit mortgage payments by sinking these savings into home equity. But that would also mean a large drawdown on investment portfolios (in turn, hitting asset prices), and less room to deploy savings for spending on items like cars and vacations.
• Housing supply released onto the market: Unfortunately, higher rates will force some homeowners to downsize or return to the rental market. That will release supply onto the market, helping to offset demand effects from lower rates and limiting the risk of a resumption of the house price bubble. If this effect is large enough, house prices could fall, hurting confidence and imposing a negative wealth effect. The size of the impact of these channels will depend on how fast rates come down. The slower the BoC normalizes, the bigger all three of these contractionary effects will be, with the “tail risk” for the economy being a full-blown housing-market-centered economic crash.
If you don’t believe that, look at the cracks already showing in the system. The banks are aware of the risks; they’re tightening access to mortgage credit through non-price channels (credit scores, down-payments, etc.), they’re no longer “terming out” mortgages to 35+ years, and they’ve increased their loan loss provisions. Arrears on mortgage lending are rising rapidly (from an admittedly low base). That will only get worse as consumers are already staring down the highest mortgage debt service ratio this century and the worst housing affordability ratio in nearly 40 years.
The Bank of Canada needs to reduce rates fast enough to avoid making a policy mistake that results in a deep recession. But even setting mortgage dynamics aside, there is a strong case for rates to go back to neutral sooner rather than later. Growth is flagging, investment is far too low to raise future growth prospects, a negative output gap is setting a broadly disinflationary backdrop, and labour supply growth is easily outstripping employment growth.
The economy needs relief from tight policy. Taking everything together, there is a strong case for an assertive, proactive approach to easing policy. At just 75 basis points of cuts over the next 12 months (which would still leave policy restrictive at 4.0% compared to the BoC’s neutral estimate of 2.25%-3.25%), we don’t think markets have gone far enough in pricing the easing cycle.
We recommend buying GoC bonds across the curve, and especially in the belly - meaning, intermediate bonds in the middle of the curve. Falling rates will keep the Canadian dollar in the doldrums.
Dylan Smith is senior economist at Rosenberg Research
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