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Housing market will be ‘first casualty’ of higher interest rates, says former Bank of Canada economist

‘When rates go up, that affordability will disappear very, very quickly,’ said Charles St-Arnaud

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Activity in the housing market is becoming further detached from fundamentals, two new reports show, reinforcing fears among some housing experts that Canada’s real-estate market has entered a bubble.

New York-based Bloomberg, the global news and data firm, last week ranked Canada as one of the bubbliest housing markets on the planet, while closer to home, a former Bank of Canada economist published research that suggests housing in Toronto and Ottawa is overvalued based on historical metrics, while Montreal is becoming increasingly so.

The heat in those eastern cities, combined with Vancouver’s chronically elevated prices, is making the national numbers frothy, as conditions in Calgary, Edmonton, and Winnipeg look reasonable, according to Alberta Central chief economist Charles St-Arnaud’s analysis. But since those places are home to 50 per cent of Canada’s population, the Bank of Canada will be forced to raise interest rates extremely carefully because low borrowing costs are the only reason housing is affordable, St-Arnaud said.


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“The housing market will probably be the first casualty of higher rates,” St-Arnaud, who previously worked at the Bank of Canada and for Morgan Stanley and Nomura Holdings Inc. in London, said. “When rates go up, that affordability will disappear very, very quickly.”

Bloomberg’s “Bubble Ranking” generates country scores by considering what it costs to buy a home compared with renting; the price-to-income ratio; inflation-adjusted price growth; nominal price growth; and the annual rate of household credit growth. New Zealand sits on top of the list, posting the highest marks in four of the five categories. Canada is second, followed by Sweden, Norway, and the United Kingdom, respectively.

Some housing experts believe Canada’s real-estate market has entered a bubble.
Some housing experts believe Canada’s real-estate market has entered a bubble. Photo by Getty Images/iStockphoto

National rankings of that sort are of limited use because housing is almost always driven by local factors, St-Arnaud said. That’s why he decided to focus on Canada’s seven biggest cities — Vancouver, Calgary, Edmonton, Winnipeg, Toronto, Ottawa and Montreal — to determine the extent to which affordability is stretched across the country.

The analysis showed that changes in interest rates could generate significant headwinds in the housing markets of major cities, as large numbers of people would otherwise struggle to keep up with lofty prices. So when Bank of Canada Governor Tiff Macklem looks to raise interest rates, as he has said he could do as soon as the second half of next year, he will have to be mindful of the ripple effect the policy change could have on Canadian homeowners.


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In May, housing prices climbed 11.3 per cent nationally from the same month last year, according to Statistics Canada, thanks in large part to the record-low interest rates that the Bank of Canada put in place to counter the COVID-19 crisis.

St-Arnaud determined that in Toronto, Vancouver, Montreal and Ottawa, a 2.5-percentage-point increase in the Bank of Canada’s benchmark borrowing rate would push those markets into “overvalued territory,” and therefore at greater risk of toppling into a bust.

To be sure, few see such a big increase coming anytime soon. However, the combination of higher prices and a smaller interest-rate adjustment would have a similar effect on affordability, St-Arnaud found. For example, a 10 per-cent jump in prices in those four cities, paired with a 1.5-percentage-point uptick in borrowing costs, would make those markets overvalued, according to his results.

On the other hand, Calgary, Edmonton and Winnipeg could tolerate an interest-rate increase of five percentage points and still remain fairly valued, according to St-Arnaud.

  1. Statistics Canada disregards the housing market in its inflation calculations, but measures “shelter” costs by recording such things as changes in rents and mortgage rates.

    Factors in Canada’s frothy real-estate market pushed inflation up in May

  2. None

    Canada in top three frothiest housing markets flashing warnings not seen since the 2008 financial crisis

  3. New mortgage borrowing rose 41 per cent in the first quarter compared to the same period in 2020, when the pandemic began, according to a release Tuesday from consumer credit reporting firm Equifax Inc.

    Canadians are taking out more and bigger mortgages, sending our debt to nearly $2.1 trillion

  4. The Bank of Canada’s most recent research suggests the froth in at least some housing markets is now worse than in 2016 and 2017.

    ‘Excess exuberance’ in housing harks back to the market frenzy of the 1990s

A higher sensitivity to the level of borrowing costs than in the past will force a go-slow approach when the Bank of Canada decides to normalize monetary policy, St-Arnaud said. For that reason, Macklem should act preemptively in lifting rates to avoid having to raise borrowing costs quickly if inflation takes off, the economist said.

“They need to take that into account …. and be very, very gradual as they can be,” said St-Arnaud. “A 25-basis-point hike will have more impact than we’ve seen over the past 20, 30 years.”

Financial Post

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