It’s not a coincidence that Canadian mortgage rates have been about as volatile as house prices. The two are inversely correlated, which means that typically, house prices rise as interest rates fall (as they have for nearly 40 years), and house prices fall when interest rates rise (as they have for the past two years).
Much of this has to do with the fact that when money is cheap, the economy runs red hot, and when the economy runs red hot, people flock to real estate as an investment or a hedge against inflation. This speculation puts more pressure on the housing market and exacerbates the inflationary impact, perpetuating the vicious cycle.
There are obvious exceptions in the current environment. This is visible in affordable Canadian real estate markets like Calgary. In these markets, interest rate pressure pushed buyers out of more expensive Canadian cities like Toronto and Vancouver. As a result, Calgary has been resilient against falling prices.
What Happens When People Can’t Pay Their Mortgage?
The upward trend in mortgage rates has put noticeable pressure on Canada’s housing market and consumers, with some notable consequences. Let’s look at a couple of examples of this distress:
- Mortgage delinquencies are rising most quickly on mortgages over $850,000. This means that we’re seeing an increase in mortgages that have been unpaid for more than 90 days.
- Power of sales in the Greater Toronto Area is up 100% since last year. A power of sale is a legal provision giving the lender the authority to sell the property and secure the mortgage.
Since interest rate hikes have started, we’ve seen everything from protests to letters from the government asking the Bank of Canada to stop. So, if Canadians are suffering so badly, why don’t they decrease interest rates?
Quite simply, they can’t right now. The central bank’s job is to keep inflation in the neutral range of 2% to 3%, and interest rates are essentially the only tool they have to do that.
So then, perhaps the better question is to ask:
When Will Interest Rates Come Down in Canada?
From my perspective, the question doesn’t have a simple answer. But we can briefly explore the full scope of the situation here. Interest rates could come down in Canada if any of the following things happened:
- Canadian Government Bond yields come down
- Inflation reached the neutral range of 2% to 3%
- The economy fell into a recession
#1. Bond Yields
Perhaps the most appropriate starting point in answering the question “When will interest rates come down in Canada?” is to say that they already have. Several Canadian lenders reduced their fixed-rate mortgages in early November. This was when the Government of Canada’s 5-year bond yield dropped from nearly 4.00% to the 3.60% to 3.70% range. Other Canadian banks echoed this reduction of 30 basis points. They then reduced their fixed mortgage interest rates by a similar amount.
So, this begs the question: why did this happen?
Government of Canada bond yields play an essential role in mortgage rates. Historically, 5-year fixed mortgage rates trade around 200 basis points (2%) higher than the Government of Canada’s 5-year bond yield. This is why you often hear that fixed mortgages are priced at GOC + 2%, with GOC being the Government of Canada.
The market determines the bond yield and serves as a forecasting mechanism. The forecast is on whether or not the market expects interest rates to rise or fall during the duration of that bond. The price of the bond determines the yield, and the market determines the bond’s price. This is what it means when someone says that interest rate hikes or cuts are “priced in” by the market.
Imagine you’re a bank. You have two options. First, you can lend to the Canadian Government. Second, you can lend to homeowners. You purchase a Government of Canada bond when you lend to the Canadian Government. The yield, or earnings, they pay you on that bond is akin to their interest rate.
Alternatively, imagine you lend to a Canadian homeowner by giving them a mortgage. Sounds more risky than the Canadian Government, right? As a lender, you might charge them a premium for that risk. So, rather than expecting them to pay the 3.65% that the Canadian Government pays, you may ask them to pay 5.65%, a 2% risk premium above the Government. This is how you get fixed mortgage rates that are priced relative to bonds with similar duration.
So, while the Bank of Canada can control variable interest rates through their overnight rate, which decides lenders’ prime rate, they can only partially control how the market prices bond yields and forecasts rates. They can influence the market with their language and response to the data points that the market uses to price bonds, such as employment or inflation, which we’ll discuss next.
#2. Inflation
Another condition that might cause mortgage rates to come down in Canada is if inflation reaches the neutral range. The neutral range is at which the Bank of Canada feels that the economy is growing moderately and purchasing power is being reduced at a sustainable rate.
If inflation reaches the target of 2% to 3%, the Bank of Canada should consider cautiously reducing interest rates slowly to see how it impacts inflation.
The more pressing questions in this regard are:
- How far down would interest rates go from where they are? They would likely not be reduced to the record-low levels we saw during the pandemic, given that an economic emergency required low rates to keep the economy moving.
- What could cause inflation to get back to the neutral range?
#3. Recession
The most likely path toward inflation reaching the neutral range is a recession, which we’re likely already seeing in Canada. Over the history of the financial system, recessions have taken an average of 16 months to bring inflation back to the neutral range, according to economist Michael Kantor.
The Bank of Canada may proactively reduce interest rates if the economy slips into a recession to engineer a “soft landing” or a softening of the economic impact. This rate reduction would stimulate the economy by making borrowing money less expensive, encouraging business activity to grow and invest using debt.
Final Thoughts
If you see one of these things taking place, the others are likely close behind. The only scenario you wouldn’t see them all occur is if the economy was in stagflation, where GDP is contracting and inflation is still persistent.
Knowing when interest rates come down is a double-edged sword. On the one hand, you’ve got the reality that lower interest rates could make mortgage payments more affordable and increase buying power for homebuyers.
On the other side, you now understand that if mortgage rates come down, it’s likely due to the economy suffering, and it will typically only occur after that’s taken place. In that regard, it becomes a bit of a “be careful what you wish for” phenomenon for those wondering when mortgage rates will come down in Canada – because it could require a recession or deflation. Neither of those is good for Canadians.
