April 14, 2022 | 13:59
The Weight of the Mortgage Rate
The Bank of Canada is now fully off the sidelines and in tightening mode, with this week’s 50 bp rate hike expected to be followed by a series of further increases this year. This is quickly changing the mortgage market, affordability and the market balance in housing. Here are some practical takeaways:
Variable rates are moving fast: We see further Bank of Canada tightening this year, which will continue to drive upward momentum in variable mortgage rates. At the turn of the year, variable rates were typically had around the 1.5% mark, but with subsequent moves by the BoC, they’ve now pushed toward the 2.25% level. Looking ahead, if our rate call is correct, these rates will be sitting around 3.25% by mid-July, and could test 4% by early next year.
The fixed-rate ship has sailed: Meantime, five-year fixed mortgage rates, which were widely available below 2% through the first half of 2021, have already risen to the 3.5%-to-4% range. Fixed rates are market-driven, and have chased a 150 bp surge in 5-year GoCs over the past year. Based on the past relationship, there might be a bit more upside in fixed mortgage rates, but the path from here will be more dictated by future moves in 5-year GoC yields—we expect about 20 bps of further upside by the end of the year.
Stress-tested out: The current state of Canada’s mortgage stress test requires a borrower to qualify at the greater of 5.25%, or the contract rate plus 2 ppts. Given the move in fixed mortgage rates, borrowers using that product are now facing a more stringent stress test (since mid-2021, 5.25% was always the cap). For example a 3.8% five-year fixed rate mortgage would now have to qualify at 5.8%, which incrementally reduces purchasing power. That’s not a massive change, but it’s certainly symbolic. Of course, borrowers really pushing the limit could now be even more incentivized to go variable, which would carve about 60 bps off the qualifying rate. On the eve of tightening, roughly 56% of new mortgage issuance was being done at variable rates.
Rollover not overly shocking: Five years ago marked the peak (at the time) of housing market froth in Ontario. The bulk of mortgage activity in 2017 was concentrated in fixed rates, but only about 38% of the total was locked in for five years. Those fixed mortgages will, through the first half of this year, be rolling out of rates that were around 2.7%; later in the year, those rollovers will be coming out of rates just above 3%. So, at this point, there is not a major shock brewing, especially if those borrowers can switch into variable rates or tweak amortizations.
Affordability bitten hard: Housing affordability, or valuations, were already historically stretched based on mortgage rates below 2%, so there will be a big bite as the market moves to the 3%-to-4% range. For example, our housing valuation measure sat at the highest since the early 1990s based on a 1.9% average mortgage rate. If we lift that rate to 3.5%, valuations get stretched beyond the peak of the 1989 bubble. Thought of another way, someone with $200k down looking at a $1 million home would have to cut their budget by 13% to maintain the same monthly payment. Based on these fundamentals, it is going to be hard to avoid an adjustment in prices.
Price impact: There is evidence on the ground that a number of regional markets have already softened. Corrections are also more common than one would think given long-term market gains in Canada. Even ignoring the extremely damaging post-1989 bear market, there have been at least six distinct regional corrections across markets like Toronto, Vancouver and Calgary, driven by various factors including oil prices, interest rates and shifts in investment. The average price decline in those episodes was 13%, with an average of 2.5 years to bottom, and almost five years to full recovery. Given how extended some markets have become today, something similar wouldn't at all come as a surprise, with some local markets faring better or worse.
Bottom Line: An adjustment to higher mortgage rates is underway, and market conditions will show their true colours by late summer, after another 100 bps of BoC tightening and when mortgage pre-approvals are expired. We suspect those conditions could feature lower demand, more ample inventory and some froth coming out of prices in a number of markets