How concerning is the potential impact of higher rates on the mortgage market?
The Bank of Canada's recent Financial System Review (FSR) has underscored several financial system vulnerabilities amidst higher interest rates across developed nations, according to BMO’s senior economist and director, economics Robert Kavcic.
Of particular concern are the stress faced by the banking sector and the state of the Canadian mortgage market.
The FSR delved into the impact of rising interest rates on the US banking sector, highlighting the failure of several regional banks.
However, the report noted that Canada has experienced limited spillover effects from global banking stresses.
“That reflects quick actions by policymakers; limited direct exposure among Canadian banks to any of those particular institutions; and, generally sound risk management and regulatory practices,” Kavcic said in a note following the publication of the report.
Nevertheless, the tightening cycle has resulted in increased funding costs and reduced market liquidity, Kavcic added.
Wholesale funding costs have noticeably risen for Canadian banks, while demand deposits have decreased in favour of term deposits over the past year.
Overall, the Bank of Canada maintained a positive view of the banking system but acknowledges symptoms that are anticipated during a tightening cycle.
Additionally, the FSR explored the current state of Canada's mortgage market, with a particular focus on the vulnerability of mortgage holders who will face higher interest rates.
Simulations based on projected rate hikes revealed that approximately 47% of mortgages will undergo an upward payment adjustment by the end of this year compared to February 2020.
The adjustment process will continue until the end of 2026 when all mortgages will have been reset to presumably higher interest rates.
A small portion of the mortgage market with adjustable-payment variable-rate mortgages has already experienced real-time payment resets.
Those with fixed-payment variable-rate mortgages are now amortizing over longer periods, potentially interest-only.
The majority of mortgage holders, however, will not see payment resets until 2025 and 2026, resulting in a payment increase of approximately 40% based on the current expected path of interest rates.
Moreover, resetting past fixed-rate mortgages will gradually lead to payments that are 10% to 25% higher over the next few years.
These characteristics of the Canadian mortgage market have played a crucial role in mitigating early damage from the tightening cycle, preventing immediate payment shocks and forced selling in the housing market.
It also granted households and the economy time to adjust to higher rates. By 2025 and 2026, various factors, including potential interest rate decreases and years of income growth, could help temper the surge in debt service ratios, Kavcic said.
“As we have long argued since the tightening cycle began, the mortgage market is not a time bomb, but more of a persistent headwind that will blow for a few years going forward,” he added. “We’re already seeing the proof of that on the ground, although the path of the job market will certainly dictate the ultimate outcome.”
