Canada's low unemployment rate provides support, but bond markets are pricing in challenging times ahead
After high mortgage growth emerged as the primary growth driver during the epidemic, the Bank of Canada's unexpected full-percentage-point interest rate increase may put the brakes on the nation's once-frothy housing market and create a drag on banks' earnings.
Early this year, the Canadian property market was booming thanks to record-low borrowing costs and changes in demand brought on by the epidemic, with prices rising by more than 50% in only two years, reported Reuters.
However, sales have significantly decreased recently, and the average selling price in May was down 12.9% from its peak in February.
"Higher mortgage rates are definitely going to be headwinds for real estate and for the banks," Paul Gardner, portfolio manager and partner at Avenue Investment Management, told Reuters.
Analysts estimate that roughly half of the loans made by Canadian banks are made up of mortgages.
But because Canada's unemployment rate is low, Gardner said people can still afford their mortgages, though they would have less money for discretionary spending. An inverted yield curve is bad for the banks, and bond markets have already priced in a recession, he said.
Canada’s central bank announced its largest rate increase in 24 years on Wednesday, hiking its policy rate from 1.5% to 2.5% and indicating that additional increases might be required. Prior to that, economists and the money markets were projecting an increase of 75 basis points.
The difference in yield between the 2- and 10-year Canadian bonds grew by 11 basis points to roughly 15 basis points in favor of the shorter-dated bond.
After the rate decision, the benchmark Canadian stock index dropped to its lowest level since March 2021, but it soon recovered and was trading flat by late afternoon.
According to Sohrab Movahedi, banking analyst at BMO Capital markets, the housing market has held up in part because of the way the product is designed: banks pre-approve or give customers a commitment on home loans.
Banks hedge themselves, he said, based on assumptions on what would result in actual loans.
"In all likelihood with the rates moving higher, the proportion of those commitments that ends up in a loan will be lower than usual. More people will choose to either buy smaller houses or defer the purchase," Movahedi said.
"If the economy is going to slow down from here, then earnings growth prospects for the banks will also slow."
