The Canadian Real Estate Association says home sales in February bounced 2.3% from the previous month. Homeowners and buyers were comforted by the guidance from the Bank of Canada that it would likely pause rate hikes for the first time in a year.

The Canadian aggregate benchmark home price dropped 1.1% in February, the smallest month-to-month decline of rapid interest rate increases in the past year. The unprecedented surge in the overnight policy rate, from a mere 25 bps to 450 bps, has not only slowed housing–the most interest-sensitive of all spending–but has now destabilized global financial markets.

In the past week, three significant US regional financial institutions have failed, causing the Fed, the Federal Deposit Insurance Corporation and the Treasury to take dramatic action to assure customers that all money in both insured and uninsured deposits would be refunded and the Fed would provide a financial backstop to all financial institutions.

Stocks plunged on Monday as the flight to the safe haven of Treasuries and other government bonds drove shorter-term interest rates down by unprecedented amounts. With the US government’s reassurance that the failures would be ring-fenced, markets moderately reversed some of Monday’s movements.

But today, another bogeyman, Credit Suisse, rocked markets again, taking bank stocks and interest rates down even further. All it took was a few stern words from Credit Suisse Group AG’s biggest shareholder on Wednesday to spark a selloff that spread like wildfire across global markets.

Credit Suisse’s shares plummeted 24% in the biggest one-day selloff on record. Its bonds fell to levels that signal deep financial distress, with securities due in 2026 dropping 20 cents to 67.5 cents on the dollar in New York. That puts their yield over 20 percentage points above US Treasuries.

For global investors still, on edge after the rapid-fire collapse of three regional US banks, the growing Credit Suisse crisis provided a new reason to sell risky assets and pile into the safety of government bonds. This kind of volatility unearths all the investors’ and institutions’ missteps. Panic selling is never a good thing, and traders are scrambling to safety, which means government bond yields plunge, gold prices surge, and households typically freeze all discretionary spending and significant investments. This, alone, can trigger a recession, even when labour markets are exceptionally tight and job vacancies are unusually high.

Canadian bank stocks have been sideswiped despite their much tighter regulatory supervision. Fears of contagion and recession persist. Job #1 for the central banks is to calm markets, putting inflation fighting on the back burner until fears have ceased.

Larry Fink, CEO of Blackrock, reminded us yesterday that previous cycles of rapid interest rate tightening “led to spectacular financial flameouts” like the bankruptcy of Orange County, Calif., in 1994, he wrote, and the savings and loan crisis of the 1980s and ’90s. “We don’t know yet whether the consequences of easy money and regulatory changes will cascade throughout the US regional banking sector (akin to the S.&L. crisis) with more seizures and shutdowns coming,” he said.

So it is against that backdrop that we discuss Canadian housing. The past year’s surge in borrowing costs triggered one of the record’s fastest declines in Canadian home prices. Sales were up in February, the markets tightened, and the month-over-month price decline slowed.

New Listings

The number of newly listed homes dropped 7.9% month-over-month in February, led by double-digit declines in several large markets, particularly in Ontario.

With new listings falling considerably and sales increasing in February, the sales-to-new listings ratio jumped to 58.4%, the tightest since last April. The long-term average for this measure is 55.1%.

There were 4.1 months of inventory on a national basis at the end of February 2023, down from 4.2 months at the end of January. It was the first time the measure had shown any sign of tightening since the fall of 2021. It’s also a whole month below its long-term average.

Home Prices

The Aggregate Composite MLS® Home Price Index (HPI) was down 1.1% month-over-month in February 2023, only about half the decline recorded the month before and the smallest month-over-month drop since last March.

The Aggregate Composite MLS® HPI sits 15.8% below its peak in February 2022.

Looking across the country, prices are down from peak levels by more than they are nationally in most parts of Ontario and a few parts of British Columbia and down by less elsewhere. While prices have softened to some degree almost everywhere, Calgary, Regina, Saskatoon, and St. John’s stand out as markets where home prices are barely off their peaks. Prices began to stabilize last fall in the Maritimes. Some markets in Ontario seem to be doing the same now.

The table below shows the decline in MLS-HPI benchmark home prices in Canada and selected cities since prices peaked a year ago when the Bank of Canada began hiking interest rates. More details follow in the second table below. The most significant price dips are in the GTA, Ottawa, and the GVA, where the price gains were spectacular during the Covid-shutdown.

Despite these significant declines, prices remain roughly 28% above pre-pandemic levels.

Bottom Line

Last month I wrote, “The Bank of Canada has promised to pause rate hikes assuming inflation continues to abate. We will not see any action in March. But the road to 2% inflation will be a bumpy one. I see no likelihood of rate cuts this year, and we might see further rate increases. Markets are pricing in additional tightening moves by the Fed.

There is no guarantee that interest rates in Canada have peaked. We will be closely monitoring the labour market and consumer spending.”

Given the past week’s events, all bets are off regarding central bank policy until and unless market volatility abates and fears of a global financial crisis diminish dramatically. Although the overnight policy rates have not changed, market-driven interest rates have fallen precipitously, which implies the markets fear recession and uncontrolled mayhem. As I said earlier, job #1 for the Fed and other central banks now is to calm these fears. Until that happens, inflation-fighting is not even a close second. I hope it happens soon because what is happening now is not good for anyone.

Judging from experience, this could ultimately be a monumental buying opportunity for the stocks of all the well-managed financial institutions out there. But beware, markets are impossible to time, and being too early can be as painful as missing out.

Dr. Sherry Cooper
Chief Economist, Dominion Lending Centres
drsherrycooper@dominionlending.ca

Today’s Labour Force Survey (LFS) for January was much stronger than expected, once again calling into question how long the Bank of Canada’s rate pause will last. This report showed no evidence that the labour market is slowing in response to the vast and rapid runup in interest rates.

Employment surged by 150,000–ten times more than expected–and most of the gain was in full-time jobs. The employment rate has returned to pre-pandemic levels. Employment rates among people 55 to 64 have been on a solid upward trend since the summer of 2022, mirroring the rise in employment over that period observed among most demographic groups.

Immigration remains a vital factor in hiring. According to the latest population estimates, in the third quarter of 2022, Canada’s population grew the fastest in over 50 years, mainly driven by an increase in non-permanent residents. In the Labour Force Survey, non-permanent residents represent the majority of a larger group, including those who were not born in Canada and have never been landed immigrants. Non-permanent residents can hold various kinds of work, study, or residence permits. On a year-over-year basis, employment for those not born in Canada and who have never been a landed immigrant was up 13.3% (+79,000) in January, compared with growth in total employment of 2.8% (+536,000).

Average hourly wages rose 4.5% on a year-over-year basis in January, down from 4.8% in December. This is good news for the inflation outlook, but it remains much above the 2% target. Year-over-year wage growth reached 5.0% in June 2022 and peaked at 5.8% in November (not seasonally adjusted).

The unemployment rate remained near a record low, holding steady at 5.0% in January, just shy of the record-low 4.9% in June and July last year.

Employment growth was most robust in wholesale and retail trade, healthcare, education, other services and construction.

Bottom Line

The Canadian jobs market is showing no signs of slowing. This has to make the Bank of Canada at least a bit nervous. The US jobs market data in January was also robust, and the Fed Chairman, Jay Powell, has assured markets that interest rates are likely to rise further.

This is the last jobs report before the Bank of Canada meets again on March 8. The CPI data for January will be released on February 21 and will be the primary factor determining Bank action. If inflation continues to decline, as expected, the rate pause will hold. If not…

Dr. Sherry Cooper
Chief Economist, Dominion Lending Centres
drsherrycooper@dominionlending.ca

As expected, the Bank of Canada–satisfied with the sharp decline in recent inflation pressure–raised the policy rate by only 25 bps to 4.5%. Forecasting that inflation will return to roughly 3.0% later this year and to the target of 2% in 2024 is subject to considerable uncertainty.

The Bank acknowledges that recent economic growth in Canada has been stronger than expected, and the economy remains in excess demand. Labour markets are still tight, and the unemployment rate is at historic lows. “However, there is growing evidence that restrictive monetary policy is slowing activity, especially household spending. Consumption growth has moderated from the first half of 2022 and housing market activity has declined substantially. As the effects of interest rate increases continue to work through the economy, spending on consumer services and business investment is expected to slow. Meanwhile, weaker foreign demand will likely weigh on exports. This overall slowdown in activity will allow supply to catch up with demand.”

The report says, “Canada’s economy grew by 3.6% in 2022, slightly stronger than was projected in October. Growth is expected to stall through the middle of 2023, picking up later in the year. The Bank expects GDP growth of about 1% in 2023 and about 2% in 2024, little changed from the October outlook. This is consistent with the Bank’s expectation of a soft landing in the economy. Inflation has declined from 8.1% in June to 6.3% in December, reflecting lower gasoline prices and, more recently, moderating prices for durable goods.”

Short-term inflation expectations remain elevated. Year-over-year measures of core inflation are still around 5%, but 3-month measures of core inflation have come down, suggesting that core inflation has peaked.

The BoC says, “Inflation is projected to come down significantly this year. Lower energy prices, improvements in global supply conditions, and the effects of higher interest rates on demand are expected to bring CPI inflation down to around 3% in the middle of this year and back to the 2% target in 2024.” (the emphasis is mine.)

The Bank will continue its policy of quantitative tightening, another restrictive measure. The Governing Council expects to hold the policy rate at 4.5% while it assesses the cumulative impact of the eight rate hikes in the past year. They then say, “Governing Council is prepared to increase the policy rate further if needed to return inflation to the 2% target, and remains resolute in its commitment to restoring price stability for Canadians.”

Bottom Line

The Bank of Canada was the first major central bank to tighten this cycle, and now it is the first to announce a pause and assert they expect inflation to fall to 3% by mid-year and 2% in 2024.

No rate hike is likely on March 8 or April 12. This may lead many to believe that rates have peaked so buyers might tiptoe back into the housing market. This is not what the Bank of Canada would like to see. Hence OSFI might tighten the regulatory screws a bit when the April 14 comment period is over.

Dr. Sherry Cooper
Chief Economist, Dominion Lending Centres
drsherrycooper@dominionlending.ca

OSFI leaves mortgage stress test unchanged

Canada’s banking regulator confirmed today it will leave the mortgage stress test for uninsured mortgages unchanged.

In its annual review of the minimum qualifying rate (MQR) used by federally regulated lenders, the Office of the Superintendent of Financial Institutions (OSFI) said the MQR has provided a margin of safety to mortgage borrowers and has better prepared them in dealing with rising rates over the course of the year.

“This margin of safety made it easier for Canadian homeowners to continue to pay their mortgages and stay in their homes when rates started rising,” Tolga Yalkin, Assistant Superintendent at OSFI, said during a media call.

He added that the MQR is one of the reasons residential mortgage defaults remain near historic lows.

“In an environment characterized by sustained high inflation, rising mortgage interest rates, and potential risks to borrower incomes, it’s prudent that lenders continue to test borrowers for adverse conditions,” he said.

While today’s decision was expected, there have been growing calls for OSFI to revisit how the mortgage stress test is applied. With interest rates for uninsured mortgages⁠—those with a down payment of at least 20%⁠—nearing 6%, it means new borrowers at federally regulated lenders must prove they can afford payments based on an interest rate of nearly 8%.

OSFI was asked if there’s a concern that the more challenging qualification conditions may drive more homebuyers who are otherwise qualified at today’s rate to alternative lenders, which generally come with higher mortgage rates.

“When we consider the basis of the MQR, we’re really looking at the risks to the financial institutions that we regulate,” Yalkin said, “ultimately with the aim of protecting borrowers and creditors and their interests and rights.”

The Governing Council of the Bank of Canada raised its target for the overnight policy rate by 50 basis points today to 3.75% and signalled that the policy rate would rise further. The Bank is also continuing its policy of quantitative tightening (QT), reducing its holdings of Government of Canada bonds, which puts additional upward pressure on longer-term interest rates.

Most market analysts had expected a 75 bps hike in response to the disappointing inflation data for September. Headline inflation has slowed from 8.1% to 6.9% over the past three months, primarily due to the fall in gasoline prices. However, the Bank said that “price pressures remain broadly based, with two-thirds of CPI components increasing more than 5% over the past year. The Bank’s preferred measures of core inflation are not yet showing meaningful evidence that underlying price pressures are easing. Near-term inflation expectations remain high, increasing the risk that elevated inflation becomes entrenched.”

In his press conference, Governor Tiff Macklem said that the Bank chose to reduce today’s rate hike from 75 bps last month (and 100 bps in July) to today’s 50 bps because “there is evidence that the economy is slowing.” When asked if this is a pivot from very big rate increases, Macklem said that further rate increases are coming, but how large they will be is data-dependent. Global factors will also influence future Bank of Canada actions.

“The Bank expects CPI inflation to ease as higher interest rates help rebalance demand and supply, price pressures from global supply disruptions fade, and the past effects of higher commodity prices dissipate. CPI inflation is projected to move down to about 3% by the end of 2023 and then return to the 2% target by the end of 2024.”

The press release concluded with the following statement: “Given elevated inflation and inflation expectations, as well as ongoing demand pressures in the economy, the Governing Council expects that the policy interest rate will need to rise further. Future rate increases will be influenced by our assessments of how tighter monetary policy is working to slow demand, how supply challenges are resolving, and how inflation and inflation expectations are responding. Quantitative tightening is complementing increases in the policy rate. We are resolute in our commitment to restore price stability for Canadians and will continue to take action as required to achieve the 2% inflation target.”

Reading the tea leaves here, the fact that the Bank of Canada referred to ‘increases’ in interest rates in the plural suggests it will not be just one more hike and done.

Monetary Policy Report (MPR)

The Bank of Canada released its latest global and Canadian economies forecast in their October MPR. They have reduced their outlook across the board. Concerning the Canadian outlook, GDP growth in 2022 has been revised down by about ¼ of a percentage point to around 3¼%. It has been reduced by close to 1 percentage point in 2023 and almost ½ of a percentage point in 2024, to about 1% and 2%, respectively. These revisions leave the level of real GDP about 1½% lower by the end of 2024.

Consumer price index (CPI) inflation in 2022 and 2023 is anticipated to be lower than previously projected. The outlook for CPI inflation has been revised down by ¼ of a percentage point to just under 7% in 2022 and by ½ of a percentage point to about 4% in 2023. The outlook for inflation in 2024 is largely unchanged. The downward revisions are mainly due to lower gasoline prices and weaker demand. Easing global cost pressures, including lower-than-expected shipping costs, also contribute to reducing inflation in 2023. The weaker Canadian dollar partially offsets these cost pressures.

The Bank is expecting lower household spending growth. Consumer spending is expected to contract modestly in Q4 of this year and through the first half of next year. Higher interest rates weigh on household spending, with housing and big-ticket items most affected (Chart below). Decreasing house prices, financial wealth and consumer confidence also restrain household spending. Borrowing costs have risen sharply. The costs for those taking on a new mortgage are up markedly. Households renewing an existing mortgage are facing a larger increase than has been experienced during any tightening cycle over the past 30 years. For example, a homeowner who signed a five-year fixed-rate mortgage in October 2017 would now be faced with a mortgage rate of 1½ to 2 percentage points higher at renewal.

Housing activity is the most interest-sensitive component of household spending. It provides the economy’s most important transmission mechanism of monetary tightening (or easing). The rise in mortgage rates contributed to a sharp pullback in resales beginning in March. Resales have declined and are now below pre-pandemic levels (Chart below). Renovation activity has also weakened. The contraction in residential investment that began in the year’s second quarter is projected to continue through the first half of 2023, although to a lesser degree. House prices rose by just over 50% between February 2020 and February 2022 and have declined by just under 10%. They are projected by the Bank of Canada to continue to decline, particularly in those markets that saw larger increases during the pandemic.

Higher borrowing costs are affecting spending on big-ticket items. Spending on automobiles, furniture and appliances is the most sensitive to interest rates and is already showing signs of slowing. As higher interest rates work their way through the economy, disposable income growth and the demand for services will also slow. Past experience suggests that the demand for travel, hotels, restaurant meals and communications services will be impacted the most. Household spending strengthens beginning in the second half of 2023 and extends through 2024. Population growth and rising disposable incomes support demand as the impact of the tightening in financial conditions wanes. For example, new residential construction is boosted by strong immigration in markets that are already particularly tight.

Governor Macklem and his officials raised the prospect of a technical recession. “A couple of quarters with growth slightly below zero is just as likely as a couple of quarters with small positive growth” in the first half of next year, the bank said in the MPR.

Bottom Line

The Bank of Canada’s surprising decision today to hike interest rates by 50 bps, 25 bps less than expected, reflected the Bank’s significant downgrade to the economic outlook. Weaker growth is expected to dampen inflation pressures sufficiently to warrant today’s smaller move.

A 50 bps rate hike is still an aggressive move, and the implications are considerable for the housing market. The prime rate will now quickly rise to 5.95%, increasing the variable mortgage interest rate another 50 bps, which will likely take the qualifying rate to roughly 7.5%.

Fixed mortgage rates, tied to the 5-year government of Canada bond yield, will be less affected. The 5-year bond yield declined sharply today–down nearly 25 bps to 3.42%–with the smaller-than-expected rate hike.

Barring substantial further weakening in the economy or a big move in inflation, I expect the Bank of Canada to raise rates again in December by 25 bps and then again once or twice in 2023. The terminal overnight target rate will likely be 4.5%, and the Bank will hold firm for the rest of the year. Of course, this is data-dependent, and the level of uncertainty is elevated.

Dr. Sherry Cooper
Chief Economist, Dominion Lending Centres
drsherrycooper@dominionlending.ca

Canada’s headline inflation rate ticked down slightly last month to 6.9%, but measures of core inflation remain stubbornly high, and food prices hit a 41-year high. Lower gasoline prices were primarily responsible for the decline in inflation in the past three months. Bond markets sold off on the immediate release of the data this morning, taking the 2-year yield on Government of Canada bonds to over 4%. This is the last major data release before the Bank of Canada’s policy rate announcement next Wednesday, October 26, which puts the potential for a 75-bps hike back in play. At the very least, the Bank will take the overnight rate up 50 bps to 3.75%, but I wouldn’t rule out another 75-bps move. Judging from experience, we may see a nod in that direction by Governor Macklem before the Governing Council meets.

Excluding food and energy, prices rose 5.4% year-over-year (y/y) in September, following a gain of 5.3% in August. Prices for durable goods, such as furniture and passenger vehicles, grew faster in September compared with August. In September, the Mortgage Interest Cost Index continued to put upward pressure on the all-items CPI Canadians renewed or initiated mortgages at higher interest rates.

Monthly, the CPI rose 0.1% in September. On a seasonally adjusted monthly basis, the CPI was up 0.4%.
Average hourly wages rose 5.2% on a year-over-year basis in September, meaning that, on average, prices rose faster than wages. The gap in September was larger compared with August.

In September, prices for food purchased from stores (+11.4%) grew faster year-over-year since August 1981 (+11.9%). Prices for food purchased from stores have increased faster than the all-items CPI for ten consecutive months since December 2021.

Contributing to price increases for food and beverages were unfavourable weather, higher prices for essential inputs such as fertilizer and natural gas, and geopolitical instability stemming from Russia’s invasion of Ukraine.

Food price growth remained broad-based in September. On a year-over-year basis, Canadians paid more for meat (+7.6%), dairy products (+9.7%), bakery products (+14.8%), and fresh vegetables (+11.8%), among other food items.

Bottom Line

Price pressures might have peaked, but today’s data release will not be welcome news for the Bank of Canada. There is no evidence that core inflation is moderating despite the housing and consumer spending slowdown. The average of the Bank’s favourite measure of core inflation remains stuck at 5.3%. Combined with the Governor’s recent harsh rhetoric, the high probability that the Fed will hike rates 75 bps at the next Federal Open Market Committee Meeting and the weak Canadian dollar, there is no doubt the Bank will increase their overnight policy target to at least 3.75%, and could well go the full 75 bps to 4.0% next week. I would bet that they will not quit there, with further hikes to come in December and next year by central banks worldwide.

The Government of Canada yield curve is now steeply inverted, reflecting the widely held expectation that the economy is slowing. The prime rate will increase sharply next week, increasing variable mortgage rates again. Fixed mortgage rates will rise as well, but not by as much, continuing a pattern we’ve seen since March when the Bank of Canada began the current tightening cycle. We are unlikely to see a pivot to lower rates in the next year as inflation pressures remain very sticky.

Dr. Sherry Cooper
Chief Economist, Dominion Lending Centres
drsherrycooper@dominionlending.ca