HAVE INTEREST RATES PEAKED IN CANADA?

In the last Tuff Risk Economic Outlook, we made note of an attempt to cool an overheated Canadian housing market by both the Federal Government and Bank of Canada, with the Federal Government introducing stricter lending rules and the Bank of Canada increasing short-term borrowing rates. A quick review of the value of real housing pricings of the U.S. vs. Canada clearly illustrates just how overheated Canada’s housing prices have become, reaching the greatest deviation 40 years.

Since 2007 the U.S. has been in somewhat of a housing crisis, with home prices today lower than before the financial crisis began. Canadian home prices however have been on a near vertical advance, increasing 50% since 2007. Many have likened this unprecedented rising in home prices to a ‘bubble’, like tulip prices in the Dutch Golden Age exactly 380 years ago.

Therefore, with the Bank of Canada’s new mandate to control practically everything, it should come as no surprise that the Bank of Canada is actively trying to curtail the advance in home prices before the bubble bursts, a level of excess some investors have already suggested has been reached.

As it stands today, most economists are suggesting the Bank of Canada will finish 2017 with one additional rate increase and as many as 3 more rate increases in 2018. There is no question the Governor of the Bank of Canada wants higher interest rates.

At Tuff Risk, we do not dispute the fact that some action from the Bank of Canada is warranted at this moment, but we do caution as to just how much rates are likely to advance. We believe there are many other factors to consider in this equation. Specifically, the fact that the advance in housing in not broad based but rather geographically concentrated in Eastern Canada. Yet this too has recently slowed down, as can be seen in the table below. Even so, the real estate market may slow down faster given home mortgage insurers are soon to introduce even more stringent mortgage qualification rules.

Another consideration to be examined when looking at Canada’s housing market is the degree of household debt to income levels.

Achieving a record high in Q2 of 2017, the average Canadian now holds debt at a level of 169.9% of disposable income, an increase of nearly 25% since 2007.

Achieving a record high in Q2 of 2017, the average Canadian now holds debt at a level of 169.9% of disposable income, an increase of nearly 25% since 2007.

According to research at Tuff Risk, much of the available home equity take-out has already occurred in Canada.

A final, consideration in assessing the Canadian economy is the recent appreciation of the Canadian dollar (CAD) and the corresponding negative effect this has had on Canada’s exports. Since May of this year the CAD has advanced from $0.729 to $0.802; a movement which in and of itself has a slowing effect on Canada’s exports, as seen in the adjacent chart.

In conclusion, Tuff Risk recognizes the Bank of Canada is likely to continue to raise interest rates in the very short term another 25 to 50 basis points, but we also believe such an advance may prove to be very short lived.

With a housing prices geographically focused in Eastern Canada, consumer debt at record levels, and exports already negatively impacted by a stronger CAD any increase in rates is sure to have a magnified negative impact on Canada’s economy.

Add to this the poor state of trade negotiations with the USA in the recently open North American Free Trade Agreement and it very conceivable that any future growth in the Canadian economy may be just a fairy-tale dream. The USA is looking for one-for-one trade where there any trading imbalance now exists. Tariffs are being proposed for all countries where a one-for-one trading relationship does not exist. Given over the last five years Canada has exported on average $25 billion more goods into the USA than it has imported, it is very likely our economy will be negatively impacted by the end of trade negotiations.

Already Canada has been hit with a 220% duty by the USA on any products produced by Bombardier and duty rates as high as 24% on softwood lumber. During a panel discussion in Washington on October 11^th, Stephen Harper, the former Prime Minister of Canada, stated that “powerful anti-trade forces that extend beyond Trump’s presidency are at play in American society and aren’t going away any time soon”, signifying he experienced strong trade resentment with Canada as far back as the Bush administration.

In 2017 our economy has been doing very well though and the adjacent chart shows just how quickly yields on 5-year Canada Government bonds have risen over the last 4 ½ months. Regrettably since mid-September, these rates have moved sideways, refusing to move higher than 1.80%. This upper resistance may be short lived, as seen many times in the past, or for all we know it may persist.

Everything appears balanced on heighted uncertainty in the Canadian economy, and growing doubt as to whether interest rates in Canada can or will move much higher.

Perhaps NAFTA negotiations will go smoothly and the Canadian economy will be able to achieve growth levels experienced over the last four quarters, or even better.

Perhaps the USA will introduce tax regulations which boost the economy South of the border.

Perhaps global demand for oil will rebound, forcing the price of Canada’s #1 export to move once again to $100.

All of us at Tuff Risk want our economy to be stronger but at Tuff Risk we require proof that things are sustainably on the mend. There is news circling of even stronger economic growth just around the corner, and that’s good. On October 10^th, the International Monetary Fund (IMF) estimated the Canadian economy will lead all the other Group of Seven countries in economic growth this year. Some economists anticipate noteworthy economic growth is as close as the next release of Statistics Canada data. Positive news seems, however, to be always tempered with not-so-good news as illustrated by Bank of Canada Deputy Governor Sylvain Leduc’s comments, made just a week prior to that of the IMF, where she states “the pace of economic growth is expected to slow over the next few quarters.”

Leduc’s statement appears to have been validated with September data just released October 20^th by Statistics Canada showing retail sales contracted 0.3 per cent in August.

Canada’s annual inflation rate, also released by Statistics Canada on October 20^th, states inflation now registers at 1.6 per cent, up from 1.4 per cent a month earlier. This figure, while showing signs of growth, was led by higher gasoline prices due to the recent hurricanes affecting output of Texas oil refineries. Excluding these volatile gas prices inflation measured only 1.1 per cent, not a sign that rising interest rates are around the corner.

To our clients, the very recent increase in market yields presents an opportunity to capture some attractive investment yields and to lock-in longer term investment rates. To our clients this also means underwriting longer-term mortgages continues to be a good strategy.

The final word however goes to Janet Yellen, Chair of the Board of Governors of the Federal Reserve System in the USA, considering renewed economic optimism in the USA. Yellen said hitting 3 per cent growth in the next five years “would be wonderful … But I think it would be challenging.”

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