What Keeps the Bank of Canada Up at Night

Dave Larock in Interest Rate Update, Mortgages and Finances

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Last week the Bank of Canada (BoC) issued its latest biannual Financial System Review (FSR), which gives us a summary of where the Bank sees “the main vulnerabilities and risks to the stability of the Canadian financial system”.

The FSR should be of interest to anyone keeping an eye on mortgage rates because it highlights the potential weaknesses in our financial system that could ultimately lead to changes in the BoC’s monetary policy, and potentially fuel a rise in bond market volatility that would trigger higher borrowing costs, if left unchecked.

This particular FSR report was even more relevant to Canadian mortgagors because two of the BoC’s three biggest areas of concern relate directly to residential mortgage borrowing. Specifically, the Bank’s top three worries are:

• Overall levels of household indebtedness
• Overvaluation in key Canadian housing markets
• Illiquidity in fixed-income markets and investor risk taking

Today’s post will provide a summary of these risks and a detailed explanation of the overlapping vulnerabilities that could exacerbate them (and in so doing, affect our mortgage rates).

Overall Levels of Household Indebtedness

The BoC continues to view our overall level of household indebtedness as “the most important domestic financial system risk”. While the Bank acknowledges that today’s ultra-low interest rates make the cost of servicing this debt affordable, it continues to worry because:

• Credit growth is rising faster than income growth, and more specifically, mortgage credit growth is now outpacing the growth of other forms of consumer credit.
• “The quality of household debt may be decreasing at the margin” (more on that below).
• The recent sharp decline in oil prices has the potential to trigger a surge in job losses that would reduce “the ability of households to service their debt”, thus creating a negative catalyst that could fuel higher default rates. The oil price drop is made worse by the fact that “Alberta households have relatively low levels of liquid financial assets, carry more debt and have a higher debt-service ratio than indebted households in other areas of the country”. That said, while the BoC feels that “the low price of oil has increased the vulnerability of the Canadian financial system to future adverse shocks”, the Bank thinks that it is “unlikely to trigger significant financial system stress” at this point
• In the latest FSR, the Bank reconfirmed that it will not use monetary policy (i.e. higher interest rates) to reign in excess borrowing. Instead, the BoC reminded our regulators that “the first line of defence for managing this vulnerability lies with the borrower and the lender”, while also confirming its assessment that current overall credit quality “remains high”. More reassuringly, after conducting its stress tests of our banks, large life insurers and CMHC, the BoC confirmed that even under “a very severe stress scenario”, these institutions would be expected to maintain “a solid ability to generate capital internally” and could thus ensure that their capital positions “remain well above regulatory requirements”.  

Overvaluation in Key Housing Markets

The BoC is worried about what it calls the “apparent trifurcation of the national housing market”, which means that it sees a three-way split in relative performance among the various regions of our country. (Try coming up with a countrywide regulatory lending framework to accommodate that!)

The Bank’s main overvaluation concerns are based on these facts:

• While “house price growth has slowed modestly … it continues to outpace income growth”. On an overall basis “the Bank’s models continue to estimate that overvaluation in national house prices (as of the last quarter of 2014) ranges from 10 to 20 per cent”. 
• “Housing market dynamics in various regions have become more diverse”, with the strongest resale activity and price growth in British Columbia and Ontario, and more moderate activity and growth levels in Quebec and Atlantic Canada. Within the BC and Ontario markets, price growth in the single-family home segments of the Vancouver and the Toronto-Hamilton housing markets has been “particularly strong”. Thus, our national housing market momentum is trifurcated into ‘rising’ (Ontario and British Columbia), ‘moderating’ (Quebec and the Atlantic provinces and ‘slowing’ (Alberta and Saskatchewan).  
• Elevated house prices increase the potential severity of a correction if we experience broad-based job losses that make overextended households unable to service their debts. While the Bank sees the probability of this risk materializing as “low”, if we were to experience widespread job losses, the impact would be “severe”.

Despite the BoC’s concerns about overvaluation in the Canadian housing market, the Bank continues to believe that “the most likely scenario is that house prices stabilize at a level consistent with underlying fundamentals” as our economy improves and “interest rates begin to normalize”. 

Illiquidity In Fixed-Income Markets and Investor Risk Taking

The BoC combines the risk of illiquidity in the fixed-income markets with the danger that ultra-low interest rates are making investors too aggressive in their chase for yield. It worries the Bank that together, these two factors have the potential to destabilize economies in several different countries. The interconnectedness of the global economy today means that instability in one area of the world could quickly exacerbate vulnerabilities in other economies, and ultimately, spread to more stable ones, like ours.

The BoC is specifically worried because:

• While increased regulatory capital requirements have made banks more “resilient to liquidity stress”, these improved safeguards have also made the role of acting as “market makers” more capital intensive, and therefore less attractive, for banks. The diminished appeal of market making has thus reduced overall market liquidity.
• Today’s paltry yields have also reduced the number of buyers in the bond market to governments and large institutions that are less yield sensitive. This further limits the bond market’s liquidity and heightens the potential for wide yield swings when market shocks occur. Basically, the quality and value of bonds is eroding at the same time that bond-market exit doors are shrinking. Both of these factors increase the risk of panic if, for example, a large group of investors decide to sell at the same time or if surprise changes in monetary policy at home or abroad were to reverse the significant foreign appetite for Government of Canada (GoC) bonds that has helped keep their yields at or near record lows.
• Today’s ultra-low fixed-income yields are compelling investors to accept increased levels of risk in order to achieve desired returns. They do this either by investing in riskier assets or by increasing their leverage (borrowing to invest), which is made easier by the record low interest rates that correspond with today’s ultra-low yields. From a specifically Canadian mortgage perspective, the search for yield has made capital abundantly available to non-prime lenders. Not surprisingly, “uninsured mortgage lending has grown faster than insured mortgage lending” at federally regulated financial institutions over the past several years, with uninsured loans growing at a rate of 10%, compared to insured-loan growth of 1%.  That said, the non-prime share of the overall residential mortgage market is still only estimated to be 3%, and the increased risk associated with this type of lending is mitigated by higher capital requirements.
• The combined potential of these risks is seen as “moderate”, although they would have “a moderately severe impact on the Canadian economy” if they were to materialize.

While not specifically listed as its own key risk, the potentially destabilizing impacts of sharply lower oil prices are a recurring theme within the three main systemic risks outlined above. Despite this, in the latest FSR the BoC also acknowledges that the negative impacts of low oil prices are mitigated “by the boost to discretionary income resulting from reduced spending on gasoline, stronger U.S. growth, a weaker Canadian dollar and stimulative monetary conditions”. Thus, given the competing effects that cheaper oil has on our overall economic momentum, we will need more time to fully appreciate its net impact on the economy.

Five-year GoC bond yields fell by two basis points last week, closing at 1.02% on Friday. Five-year fixed-rate mortgages are offered in the 2.49% to 2.59% range, and five-year fixed-rate pre-approvals are available at rates as low as 2.69%.

Five-year variable-rate mortgages are available in the prime minus 0.65% to prime minus 0.80% range, depending on the terms and conditions that are important to you.

The Bottom Line: The latest FSR indicates that while the BoC worries about threats that could undermine our financial stability, at this point it believes that they have a relatively low probability of actually materializing. This view of significant but unlikely to occur threats should allow the Bank to maintain its cautious monetary policy approach going forward, and is consistent with my view that our mortgage rates should remain relatively stable for the foreseeable future.   

David Larock is an independent mortgage planner and industry insider specializing in helping clients purchase, refinance or renew their mortgages. David's posts appear weekly on this blog, Move Smartly, and on his own blog: integratedmortgageplanners.com/blog Email Dave