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Bank of Canada Rate - Managing Expectations for the Announcement on January 25th

<strong>Bank of Canada Rate - Managing Expectations for the Announcement on January 25th</strong>

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The Bank of Canada’s (BoC’s) prolonged tightening of economic activity over the last several months has seen Canadian home prices drop predictably, with the average year-over-year decline in house prices from November 2021 netting approximately 39% as of the end of November 2022. Yet despite persistent unemployment in multiple areas throughout the nation, this has not translated into respite regarding rate hikes due to inflationary pressure. This environment leaves buyers uncertain about what avenues to manage future borrowing plans successfully. 

In this article, we aim to provide an update on how economic indicators are adjusting from the BoC’s December 7th rate hike and the influence it will have on the mortgage and housing market for the next rate decision expected on January 25th.


Key Takeaways

  • Unemployment is reducing, and job numbers are showing growth 
  • Inflation has hardly been beaten, remaining 5% higher than BoC’s target
  • Pandemic and deglobalization is decoupling inflation from solely being controlled by rate hikes
  • Expect the BoC to change inflation target or continue with more rate hikes in 2023

Housing Prices Still Sliding Due to Inflation

Housing markets in Canada remain challenged, as prices continue to decline. National house price was down 12% from a year ago in November 2021. Despite this, buyers are slowly re-entering the market, creating much-needed balance. According to data published by The Canadian Real Estate Association (CREA), there has finally been a visible reprieve back toward balance in the industry. 

It looks like the Bank of Canada still hasn’t succeeded in its mission to rein in inflation as measured by Consumer Price Index (CPI). At times, it may feel like a lost cause – though there may be some good news. We’re starting to see a change with various global pressures, such as supply chains. It’ll be an uphill battle against inflation, but at least there are signs it’s beginning to trend down.  The CPI decreased a mere 10ths of a percentage point, leaving CPI well almost 5% above the BoC’s 2% target.

Housing is the most interest-sensitive industry, so the effects of inflation have been felt more quickly. There are also slowing signs in other parts of the economy that are just as sensitive to interest rates as housing. Communications, energy, industrials, and technology are all investment and credit-heavy sectors.  As interest rates increase, consumer carrying costs increase, which curtails more investment in these industries. 

In addition, these industries rely on borrowed capital to invest in new projects, whose increased costs affect their bottom line.  As the full effects of interest rate hikes can take upwards of a year to be felt throughout the economy, it may be reasonable to believe that the BoC will pause rate hikes to see if its monetary policy has expected results.  A rate reversal is promised and expected, but the timing of it seems to be misplaced even by policymakers. The question remains – when will the Bank of Canada pause for a turnaround?

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Rate Hikes Having No Effect on Reducing Inflation

In exercising a financial approach for combatting inflation, the Bank of Canada has, at times, done so by increasing interest rates. Its goal was to increase unemployment from the market, reducing people’s ability to buy goods. This diminishing buying power leads to a sharp decline in consumer spending. In these past cases, when excessive inflation was prevalent, the Bank of Canada’s unflinching stance resulted in drastic reductions in commodity prices. At the end of November, inflation seems much unchanged compared to a few months back, as it is still hovering around 6.8%.

As the world’s economies are interconnected and ever-changing, geopolitical forces can shape our financial future. China is having a homegrown property crisis while also dealing with COVID lockdowns, which has impacted their demand. This effect could prove to be beneficial for us or altogether detrimental. 

Most of our goods come from China, and surging COVID during the lunar new year may slow down the supply chain. Inflation due to supply chain issues could provide an excuse for the BoC a way out from hiking rates as much.  This “silver lining” may protect us from more severe rate hikes on January 25th.  Conversely, if the supply chain situation improves the flow of goods, it could effectively delay similar results until the following BoC meeting on March 8th.

Figure 1 – Canadian CPI Year-over-Year (% change) fluctuations between January 2019 (Pre-pandemic) to the present. Source Stats Canada

Zooming in on monthly fluctuations of the Canadian Consumer Price Index to illustrate the volatility of inflationary pressures during the same period.

Figure 2 – Canadian CPI Month-over-Month (% change) fluctuations between January 2019 (Pre-pandemic) to the present. Source Stats Canada

Increasing Unemployment to Rebalance Economy

The Bank of Canada has been facing a precarious challenge outside its control.  labour market is stubbornly tight – adding another 104,000 full-time jobs to the market in December on an expectation of 5,000. Unequivocally, something has to give that starts a domino effect of events. More goods circulating will mean companies need to scale back on their prices to stay competitive. When the labour market had remained heavily tight for some time now, many businesses had begun raising prices to compensate for increases to wages to attract workers – additionally fueling inflation. 

Thenational unemployment has inched down instead of up, likely in protest to the latest rate hikes by BoC.  Economists had forecasted that only about 5,000 jobs would be added; a whopping 99,000 more jobs than expected were added to the economy in December. Employment came roaring back from the slump this past summer, adding another 130,000 Canadians to the workforce. Some employees constitute part-time employment – meaning that a total of 104,000 full-time jobs were added to the economy. 

The unemployment rate fell a tenth of a percentage point as it dropped from 5.1% to 5%.  It could be due to labour shortages in various industries affected by illness. This past week the Globe and Mail reported that StatsCan’s recent report illustrates a stark situation: illness and disability have taken an increasing toll on the workforce, causing absenteeism to spike in December — more than double the pre-pandemic rate. 8.1% more employees were absent in the first week of December compared to only 6.8% the previous month – far higher than an average December pre-pandemic.

December saw a slight slowdown in hourly wages compared to the previous month, yet still represented an impressive year-over-year jump of 5.1%. Unfortunately for workers, this rate was lower than inflation at 6.8%, continuing seven months of sustained wage growth above 5%. This is still not enough to beat inflation, thus seeing a decline in purchasing power for the average worker.  These two changes led Andrew Grantham, a senior economist at CIBC Capital Markets, to suggest the increased staffing could be due to companies needing to achieve production losses suffered during the pandemic – and make up for lost hours due to illness.

Avoiding A Double Recession May Cause An Over-Reach In Its Goal to Quell Inflation

Rates were higher in the 1970s and 1980s, but incomes were also lower in comparison.

The average home cost 5 times an individual’s income back then, whereas now it costs almost 10 times an individual’s income. In the past, people could buy a home with no down payment or 40-year amortization. Now people need a down payment where that money down could be 5 years of disciplined savings for an average Canadian – with an amortization limited to 25 years.

Most people in North America in the 1970s and 1980s remember the consistently tight monetary policies of the Federal Reserve (the Fed) and the Bank Of Canada (the BoC). Policy rates were cut in 1976, but inflation had not peaked. By 1980, rates had to be doubled overnight to prevent more casualties from inflation pressures. Central bankers of the 1970s learned that it is important to only ease up on fighting inflation once it has been defeated.

Where the Fed and Bank of Canada are cautiously drawing conclusions: The 1970s showed inflation (illustrated below with the Canadian Consumer Price Index) can be volatile and persistent. Proclaiming success too soon on inflation after a temporary reprieve can result in an even bigger spike later.

Figure 3 – Canadian CPI Year-over-Year (% change) fluctuations between January 1970 and December 1985. Source Stats Canada

Zooming in on monthly fluctuations of the Canadian Consumer Price Index to illustrate the volatility of inflationary pressures during the same period.

Figure 4 – Canadian CPI Month-over-Month (% change) fluctuations between January 1970 and December 1985. Source Stats Canada

The Bank of Canada is watching lagging indicators such as GDP, inflation measured by the consumer price index (CPI), unemployment, trade balance, corporate profits, and labour costs NOT seeing declines. December numbers have yet to be out, but GDP was up 0.1% each month in October and November. As the experience of the double recession has central bankers, this is not a signal to be dovish in its stance on inflation. 

On the other hand, almost half a century makes for a very changed world – with it, the whole economy.  In the 1970s, we didn’t have the internet or online shopping, much less global supply chains.  That said, things are becoming more expensive to source and transport as purchasing power increases worldwide.  At the end of December 2022, in the Globe & Mail, John Rapley reported that we might never hit BoC’s target of 2% inflation again.  It was 30 years of cheap labour and globalization that inflation has remained so low.  Wages had fallen as cheap labour from an additional 2 billion workforce, mainly being added from China and India, drove prices down in the West.  

An increase in the advancement of technology in transportation, communication, and banking made it easier for companies to offshore their labour making wages trend downwards. The COVID pandemic and Russia’s ongoing war on Ukraine affect our global trade. Additionally, making India and China turn inward thus given rise to more demand by Western workers for higher wages – which comes with an increased cost of production.  Despite the economy slowing – wages are still rising. This may be the year the BoC abandons its 2% inflation target.  Central bankers, as all economists, want to be doubly sure to avoid repeating a double recession.v

Inverted Yield Curve Stayed Curved, But Recession not in Sight

The bond market has been flashing red –The yield curve has been inverted more recently. What is a yield curve? A bond has an interest rate, also called a yield. The yield curve is like plotting the rate of interest that the government pays you on a bond over time. Bonds are bought and sold by bond traders as risk-free government debt on the capital market. The daily price is based on the anticipation of risk for the bond’s duration until maturity. Fixed-rate mortgages are priced based on these same bonds.

Typically longer-term bonds have higher yields as you take higher risk by holding them for longer. Generally speaking, the 10-year government (Government of Canada) bonds have a higher rate of return than the 2-year government bond. The 10-year bond is over 100bps (1%) below the 2-year bond. The bond yield curve has inverted, which has only happened a few previous times in recent history. The other two times that this happened were during the 1990s when we had a prolonged recession and once before when it was the Great Depression.

10-year U.S. Treasury yield minus two-year U.S. Treasury yield. This is the same yield curve pattern that occurs in the US before a recession. This time, the same pattern is showing up worldwide and in Canada’s bond market. Source: Globe & Mail St Louis Federal Reserve

Most times, the 10-year yield bond would be priced higher than the 2-year bond. This implies that it would be more of a risk for the lender (investor) to lend money to the borrower (government) for a longer period (over 10 years) than a shorter period (over 2 years), so the yield is expected to be higher for the longer term. Conversely, if the yields get reversed, the current and short-term situation for the government could be more financially sound so that the rates could be higher. However, as the 10-year bond is pricing lower, investors (lenders) believe that they expect the government to get their books in order within a longer period.

This time around, the inversion on the yield curve is deep, meaning that Canada is headed for a recession this year. Recession is not all bad news. Our economy will show negative numbers quickly once we hit a recession. These numbers would have to include a remarkable drop in employment. 

Originally the narrative was that some of the inflation had been to the CAD/USD foreign exchange rate. On the other hand, the US Dollar has seen much more volatility than the Canadian Dollar. But unlike the other developed economies’ currencies, the Canadian Dollar has faired much better, avoiding the steam-roller effect that the US Dollar has played on many other currencies such as the Euro, the Pound Sterling, the Japanese Yen, and the Australian Dollar.

The Catch-22 for us is that we are not seeing a remarkable drop in inflation or unemployment. On the contrary, we have seen a minimal drop in CPI between July and November, which may reverse once December numbers come out.  We are also seeing an increase in employment from the numbers from December, meaning that the rate hikes are not having the Bank of Canada’s desired effect on inflation.

Housing Supply Shortages Set Dire Expectations for Future Affordability

It’s been 70 years since the federal government set up the Canadian Mortgage Housing Corporation (CMHC) through the National Housing Act (NHA) to meet the housing demand created by the baby boom in post-war Canada. The NHA and CMHC were set up to introduce policy and financial instruments to make financing a home much easier for the average Canadian. However, since then, we have seen our population double, and the quality of immigrants coming with professional designations has remarkably increased in the last 20 years.

As China and the US see a high inflation setback, the material supply will increase. Albeit, our borrowing capacity lags with short-term housing demand dwindling – leaving no appetite for housing even if there is much long-term need. In the last round, the Fed showed a more cautious approach than the Bank of Canada as they increased by a bigger chunk, relatively 50 bps (0.50%) in tandem with our 50 bps (0.50%), bringing the United States 25 bps (0.25%) higher at 4.50% versus Canada’s 4.25%.  We’ll soon see what path the central banks take this time around.

U.S. Federal Rate (upper limit) and Bank of Canada Key Target Rate. Source: CBC News | Federal Reserve

Currently the US Federal Rate sits 25bps (0.25%) higher than the Bank of Canada’s Key Overnight Rate. Still, the US economy can usually absorb higher rate hikes than the over-sensitive Canadian cousin. After all, in the US, it is common to have 15-year and 30-year locked mortgage rates. In contrast, in Canada, 5 years is the most common, and at best, most borrowers break it before maturity.  For this reason alone, most US mortgages, except for purchases, may not see the full effect of this market cycle’s rate hikes.  

In the US, the Fed is trying to curb the runaway stock market.  The goal there for the Fed is to reduce corporate risk appetite by making borrowing more expensive.  Likely, the Fed may not halt hikes before another 100 bps  (1%) – meaning another 50 bps (0.50%) and 50 bps (0.50%) increase in the upcoming meetings.  They may even wait for more lagging economic indicators to show improvement before halting.

How Bank of Canada Rate Increases Affect Your Mortgage Payment and Qualifying Income

In this section, we have simplified numbers by tabulating average mortgage balances and their corresponding mortgage payment, stress-tested qualifying mortgage payment, and the qualifying gross annual income needed to support the mortgage balance. 

Each 25bps (0.25%) on a $100,000 balance equals $14 per month in a mortgage payment. This same mortgage payment change will require an additional $3400 annually in income to qualify for each similar increase.

Below are charts to help you conceptualize mortgage payments and qualifying income for each $100,000 balance with each 25 bps increase. Each increase by the central bank on its overnight rate will impact all lenders’ prime rates, including nesto’s.

Current Rate at 5.25%

Mortgage Amount Mortgage Payment Qualifying Payment Income Required
100000 595.92 715.92 42,260.23
200000 1,191.84 1,431.84 58,577.49
300000 1,787.76 2,147.76 79,009.03
400000 2,383.68 2,863.68 99,440.57
500000 2,979.60 3,579.60 119,872.11
600000 3,575.52 4,295.52 140,303.66
700000 4,171.44 5,011.44 160,735.20
800000 4,767.36 5,727.36 181,166.74
900000 5,363.28 6,443.28 201,598.29
1000000 5,959.20 7,159.20 222,029.83
Calculations are made with nesto’s mortgage payment calculator using current rates as advertised on our website. (as of January 10, 2023). Stress-tested qualification based on rate (5.25%) + 2% but mortgage payment based on actual contract rate (5.25%). Assumptions made: taxes are $5000 annually, heating is $100 monthly, 25yrs amortization, no condo fees and qualifying income inclusion of 35% (insurable GDSR criteria apply).

If Rates Increase by 25bps to 5.50%

Mortgage Amount Mortgage Payment Qualifying Payment Income Required
100000 610.40 731.56 42,796.46
200000 1,220.80 1,463.12 59,570.40
300000 1,831.20 2,194.68 80,498.40
400000 2,441.60 2,926.24 101,426.40
500000 3,052.00 3,657.80 122,354.40
600000 3,662.40 4,389.36 143,282.40
700000 4,272.80 5,120.92 164,210.40
800000 4,883.20 5,852.48 185,138.40
900000 5,493.60 6,584.04 206,066.40
1000000 6,104.00 7,315.60 226,994.40
Calculations are made with nesto’s mortgage payment calculator using current rates as advertised on our website. (as of January 10, 2023). Stress-tested qualification based on rate (5.50%) + 2% but mortgage payment based on actual contract rate (5.50%). Assumptions made: taxes are $5000 annually, heating is $100 monthly, 25yrs amortization, no condo fees and qualifying income inclusion of 35% (insurable GDSR criteria apply).

If Rates Increase by 50bps to 5.75%

Mortgage Amount Mortgage Payment Qualifying Payment Income Required
100000 625.03 747.33 43,337.14
200000 1,250.06 1,494.66 60,573.60
300000 1,875.09 2,241.99 82,003.20
400000 2,500.12 2,989.32 103,432.80
500000 3,125.15 3,736.65 124,862.40
600000 3,750.18 4,483.98 146,292.00
700000 4,375.21 5,231.31 167,721.60
800000 5,000.24 5,978.64 189,151.20
900000 5,625.27 6,725.97 210,580.80
1000000 6,250.30 7,473.30 232,010.40
Calculations are made with nesto’s mortgage payment calculator using current rates as advertised on our website. (as of January 10, 2023). Stress-tested qualification based on rate (5.75%) + 2% but mortgage payment based on actual contract rate (5.75%). Assumptions made: taxes are $5000 annually, heating is $100 monthly, 25yrs amortization, no condo fees, and qualifying income inclusion of 35% (insurable GDSR criteria apply).

If Rates Increase by 75bps to 6%

Mortgage Amount Mortgage Payment Qualifying Payment Income Required
100000 639.81 763.22 43,881.94
200000 1,279.62 1,526.44 61,587.09
300000 1,919.43 2,289.66 83,523.43
400000 2,559.24 3,052.88 105,459.77
500000 3,199.05 3,816.10 127,396.11
600000 3,838.86 4,579.32 149,332.46
700000 4,478.67 5,342.54 171,268.80
800000 5,118.48 6,105.76 193,205.14
900000 5,758.29 6,868.98 215,141.49
1000000 6,398.10 7,632.20 237,077.83
Calculations are made with nesto’s mortgage payment calculator using current rates as advertised on our website. (as of January 10, 2023). Stress-tested qualification based on rate (6%) + 2% but mortgage payment based on actual contract rate (6%). Assumptions made: taxes are $5000 annually, heating is $100 monthly, 25yrs amortization, no condo fees and qualifying income inclusion of 35% (insurable GDSR criteria apply).

In the worst-case scenario of a 75bps increase, a client carrying a $100,000 balance would need an income boost of $2680 annually to qualify. For a $1 million balance, they’d need an increase in income of $24,806 annually to qualify. This worst-case scenario is quite unlikely as the Bank of Canada understands from experience that their rate increases take approximately 6 months to a year to impact or work through the economy fully. If they overestimate the amount of weight they add to the economy, it may struggle to get out of a recession when it finally gets to one.

Options For Your Variable Rate Mortgage During Inflation

So what can you do here? First, consider all your options: can you afford to carry a larger payment? Are you planning on keeping the home for a longer term? What is the cost assessment of renting versus homeownership? Do you expect to save money if you delay your purchase? Let’s look at these questions one at a time.

Early Renew Your Mortgage to Lock in Your Rate

If you can afford to carry a larger payment but prefer to have your sanity back, you could have the ability to early renew your variable rate to a fixed rate and lock in the payment for the next 3 to 5 years. Overall the rate may be lower than the current variable rates. Still, there is a chance that if the longer-term outlook is better than the shorter-term, variable rates may overtake fixed ones before inflation is tamed. If you have already purchased but qualified on a variable rate, then review with your lender to see if you can move forward with a fixed rate. Or, if qualifying is the issue, you can early renew to a fixed rate almost immediately after your closing, that is, once your mortgage is funded.

Extending Your Mortgage Term to Hedge Inflation

As discussed earlier, with the indication from the inverted yield curve, we’re likely to see rates drop in a year or two. So if you’re up for renewal, the best option is to look at shorter-term fixed rates to provide the stability you need. If your risk and preferences allow you to carry a variable-rate mortgage (with static payments), you’ll be the first to notice savings once rates turn around. If rates keep increasing, just beware of trigger rates that can creep up on your variable-rate mortgage (VRM). Without updating your payment, your VRM can quickly reach a trigger point if you’re carrying a default-insured mortgage. Your alternative option is to choose an adjustable-rate mortgage (ARM) where your payments fluctuate with your rate – such that trigger rates or trigger points do not impact you.

Renting While You Wait for Inflation to Settle Down

You can also compare the costs of renting versus ownership. Assuming that the average rent for a 1-bedroom apartment is $2000 across the country, you’re looking at $24,000 in annual rent. Will $24K cover your annual mortgage payments – probably not – but then again, you won’t build equity by renting. Once the inflationary pressure settles, homes will start rising again, so then you may have to translate any savings into a premium added to the increased cost to purchase your home. Higher rates may not last as long as it takes to build up savings for a downpayment. Therefore, if your financial situation allows you to buy now, I recommend locking in a rate and finding the perfect home.

Being able to delay your purchase to avoid higher rates and possibly buying for a lower value may sound like a good idea. This could help you save money if you get the timing right. If you get it wrong, the market will quickly revert to a seller’s market. What are the benefits of buying now? The biggest benefit is that it is a buyers’ market for the first time in a decade. You don’t have to give up anything. You can still place conditions and do your due diligence before buying one of your lifetime’s biggest investments. Previously you’d have had to waive your conditions, be in bidding wars and maybe even write a love letter to the seller before they even looked at your offer seriously. Now you can do whatever it takes to ensure you’re perfectly happy with your purchase. In this market, I have even heard of people putting a conditional purchase on 90 days to complete a firm sale of their home. Before 2022, this was almost unheard of unless you were an insider in the transaction or knew the seller well.

Home Prices Usually Don’t Go Down

In many ways, the stock market behaves similarly to the housing market – when the costs to borrow money go up, then the stimulus to invest goes down. Looking at the stock market, you’ll notice that the best-performing years are right after the worst-performing years. You’ll find a similar case with the housing market – both depend on the labour market. When employed with little or no risk of layoff, people are more likely to buy homes or stocks. The only difference is the price tag for a unit of a company’s stock versus the price of any home in Canada.

We expect a large influx of immigrants – especially as we see labour shortages that need positions to fill before the labour market can tighten further. We know the demand for housing already exists as housing affordability advocates have made it clear in many publications – even more so when the housing market was surging – increasingly highlighting the unaffordability factor. The vast majority of immigrants will settle in Southern Ontario and Lower BC. These regions will be quite welcoming as even more temperate climates as global warming escalates.

If you want to own a home in the next couple of years, this is the most suitable time for you! Prices are starting to reach lows not seen in 3 years and possibly could get lower after the next rate hike expected on December 7th. But be mindful that if you purchase after the rate hike, then your qualifying amount could be lower than what it is currently due to the requirement of stress-testing your mortgage payment on the possibly higher rate plus 2%. Like stocks, your home’s value will only go up once rates start coming down.

Final Thoughts

The stubbornly resilient Canadian economy has given the Bank of Canada a challenge that has gone so far unbeaten.  As the Bank of Canada hammers away at the economy by continuing its march with rate hikes – core inflation keeps surging, and the employment numbers show growth month over month. More often, these indicators are  positive news, but for housing to become more affordable again, we need rates to go down.

Navigating the rocky waters of dramatic economic downturns can be daunting. As the recession rears its ugly head, it brings unintended healing effects.  If you’re looking for sound financial advice to reach your goal of homeownership, then reach out to one of nesto’s professionally qualified mortgage experts, who will guide and advise you through the homeownership process.


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