The Bank of Canada and the Housing Market: an Unenviable Position

The Bank of Canada is in a very difficult position because of House Prices for a number of reasons.  It is our current thesis that they are stuck between a rock and a hard place.  The rock being the need to raise interest rates to combat inflation and a sinking Canadian dollar and the hard place being the massive housing bubble and huge levels of consumer debt in Canada. Some of these difficulties are also faced by central banks around the world and some are uniquely Canadian.

Interest Rates

In this global environment of rising interest rates and inflation, the Bank of Canada feels compelled to raise rates and they have done so recently.  However, the Bank is well aware that house prices are astronomical in many major Canadian cities.   When the government raises rates, it will cause many new mortgages and many renewing mortgages to have higher rates.  But many Canadians have purchased a house that they can barely afford with the current rates.  Additionally, Canadians have accumulated the highest level of unsecured debt in Canadian history.

If the Fed raises rates, they will see the dollar appreciate (which is bad for exports) and, worse, they might unwind the massive housing bubble.  If they don’t raise rates, we could see rampant inflation, and a lower dollar.   Rock, meet hard place.

So, how do you fix this problem? It’s too late, basically.  Rates have remained low for such a long time that a gigantic housing and personal debt bubble has been blown Canada.  No matter what the government does, we’re going to feel some major financial pain in the years to come.

Protectionism

Recently the US government has made serious rumblings of a coming trade war.  Since Canada relies heavily on exports to the USA, this again makes things difficult for the Bank of Canada.  If they don’t raise rates and the USA, the dollar will likely decline or stagnate which will make Canadian exports even more attractive, which will then, in turn make tariffs on Canadian goods more likely in this environment.

CMHC

The Canadian Mortgage and Housing Corporation (a topic that we will soon be writing more extensively on) provides insurance of sub prime loans for Canadian lenders.  The cynical view is that they are there to protect the banks from losses from potential bad mortgages.

If the Bank of Canada raises rates, you will see more mortgage defaults and generally these defaults will more often be loans that are insured by CMHC.  Eventually, the losses might exceed the reserves that the CMHC has set aside for defaults and then you will see the Federal government bail out the CMHC.

Where from here?

We believe that the Bank of Canada will try to raise rates a few more times, but then the housing bubble will burst (if it hasn’t already) and they will reverse these rate increases to combat rapidly declining house prices.   It’s going to get nasty and I don’t believe the Bank can do anything about it,