Canada's Economy: The Straw That Broke the Camel's Back?

The odds of recession are rising in developed markets (DM) as central banks near the likely conclusion of their rapid monetary policy tightening cycle in response to the surge in post-pandemic inflation. However, in few countries is the risk of overtightening as acute as in Canada, in our view. Indeed, the country remains one of the most interest-rate-sensitive DM economies, as households are more highly leveraged than in most of DM and the majority of this debt is in mortgages with a term of five years or less.

Inflation fears prompt BOC to restart rate hikes

The Bank of Canada (BOC) restarted its hiking cycle this summer following a five-month pause from the initial 425 basis points (bps) increase. It added 50 bps of tightening across its June and July meetings, raising the policy rate to its current 5% level.

Despite continued improvements in the year-over-year headline inflation rate, core inflation has remained above the Bank of Canada’s 2% target, and the Governing Council stated that there was excess demand in the economy when it resumed increasing the policy rate in June. The three-month moving average of the BOC’s preferred CPI-trim and CPI-median inflation rates has been stuck between 3.5% and 4% since the third quarter of 2022. In addition, the newly introduced core services excluding shelter inflation measure remains above 4%.

Meanwhile, consumption grew 5.8% in the first quarter of 2023, surprising BOC officials, especially given strength across both services and more interest-rate-sensitive sectors such as automobiles and furnishings, according to the minutes of the June meeting. Since the BOC began raising the policy rate in 2022, there has been a rapid increase in the number of mortgages with extended amortization periods longer than 30 years. This has helped lower the pass-through of rising interest rates on monthly mortgage payments and – combined with strong population growth and a large stock of excess savings – likely blunted some of the impact from previous rate hikes. 

Higher rates will start to bite

Nevertheless, we believe that strength on the surface masks some ominous underlying developments. For one, we think the recent strength in the housing market largely reflects a temporary easing of global financial conditions following the U.S. regional banking crisis and pent-up demand from last fall and winter. Furthermore, as mentioned earlier, banks have thus far shielded borrowers from a large part of the BOC’s tightening by extending mortgage amortization periods. This cannot continue indefinitely.

Strong first-quarter consumption should wane as these higher rates affect households. The Bank of Canada estimates that as of May 2023, payments on just over a third of mortgages had increased since the current tightening cycle began. The BOC expects nearly half of mortgages will have reset to higher rates by the end of 2023, and just under two-thirds by the end of next year.

Meanwhile, the recent lengthening in mortgage amortization periods will likely leave households more indebted for longer just as Canadian household debt-to-disposable income ratios near historical highs. Even with the prolonged amortization periods helping to smooth the shock from higher mortgage rates, the Canadian mortgage debt service ratio already exceeds that of the U.S. in the run-up to the Global Financial Crisis.

Taken together, rising debt-servicing payments should pressure consumers and help ease the excess demand in the economy.

Investment implications

While the resumption of monetary tightening could help return inflation to target sooner, it raises the risk of a hard landing. Households have yet to feel the full effects of the initial 425 bps of tightening, not to mention the additional 50 bps from the last two meetings. Meanwhile, an increasing number of households will have to renew their mortgages at higher rates. We also expect a weaker U.S. economy and broader slowdown in global activity will weigh on exports, reducing labour demand and compounding the pressure on household disposable incomes.

The risk is that many Canadians will face increasing payments on their debt exactly when their jobs are less secure as the economy slows and employment growth begins to lag the rapid increase in the working-age population.

Against this backdrop and given current valuations, we view the front end of Canada’s yield curve – which is priced for another 15 bps of hikes and fewer cuts in 2024 compared to the U.S. – as attractive relative to both longer-dated Canadian bonds as well as U.S. bonds.