As was universally expected, the Bank of Canada’s Governing Council hiked overnight rates this morning by 25 basis points taking the benchmark yield to 1-3/4%. This marked the fifth rate increase since the current tightening phase began in July 2017 (see chart below). The central bank stated it would return the overnight rate to a neutral stance, dropping the word ‘gradually’ that was used to describe the upward progression in yields since this process began. Market watchers will certainly note this omission. For the first time in years, the Bank has acknowledged it expects to remove monetary stimulus from the economy entirely.

So what is the neutral overnight rate? According to today’s Monetary Policy Report (MPR), “the neutral nominal policy rate is defined as the real rate consistent with output sustainably at its potential level and inflation equal to target, on an ongoing basis, plus 2% for the inflation target. It is a medium- to long-term equilibrium concept.” For Canada, the neutral rate is estimated to be between 2.5% and 3.5%, which implies that at a minimum, three more 25 basis point rate hikes are likely over the next year or so.

The Bank of Canada emphasized that the global economic outlook remains solid and that the U.S. economy is particularly robust, but is expected to moderate as U.S.-China trade tensions weigh on growth and commodity prices. The new U.S.-Mexico-Canada Agreement (USMCA) eliminated a good deal of uncertainty for Canadian exports, which will reignite business confidence and investment. Business investment and exports have been of concern in recent quarters, and the Bank is now looking towards a resurgence in these sectors, augmented by the recently-approved liquid natural gas project in British Columbia.

A continuing concern, however, is the decline in Canadian oil prices. Western Canada Select (WCS), a local blend that represents about half of Canada’s crude oil exports, has declined about 60% since July as global oil prices have risen (see chart below). WCS plunged below US$20 a barrel last week posting the biggest discount to West Texas Intermediate (WTI) on record in Bloomberg data back to 2008. WCS generally tracks heavy oil from Canada, which typically trades at a discount to WTI because of quality issues as well as the cost of transport from Alberta to the refineries in the U.S.

Canadian pipelines are already filled to the brim. The inability of the Canadian oil industry to build a major pipeline from Alberta to either the U.S. or the Pacific Ocean is increasingly dragging down domestic oil prices. Oil-by-rail shipments to the U.S. are at an all-time high, but this is an expensive and potentially unsafe option and precludes Canadian oil exports to China and Japan.

An even broader concern is the impact of higher interest rates on debt-laden consumers. The Bank is well aware of the risks, as the MPR cited that “consumption is projected to grow at a healthy pace, although the pace of spending gradually slows in response to rising interest rates… Higher mortgage rates and the changes to mortgage guidelines are affecting the dynamics of housing activity. Housing resales responded quickly to the new mortgage guidelines, and the level of resale activity is expected to continue on a lower trajectory than before the changes. New home construction is shifting toward smaller units, although stronger population growth is estimated to raise fundamental demand for housing.”

Household credit growth has slowed, and the share of new mortgages with high loan-to-income ratios has fallen. The ratio of household debt to income has levelled off and is expected to edge downward (see chart below).

Low-ratio mortgage originations declined by about 15% in the second quarter of 2018 relative to the same quarter in 2017 (see charts below). The MPR shows that “while activity fell for all categories of borrowers, the drop was more pronounced for those with a loan-to-income ratio above 450%, leading to a decline in the number of new highly indebted households”.

Bottom Line: The Bank of Canada believes the economy will grow about 2% per year in 2018, 2019 and 2020, in line with their upwardly revised estimate of potential growth of 1.9%. The Bank asserts that mortgage tightening measures of the past two years have “reduced household vulnerabilities,” although the “sheer size of the outstanding debt means that vulnerability will persist for some time”. That is Bank of Canada doublespeak. What it means is expect three more rate hikes by the end of next year.

With the Bank of Canada widely expected to increase interest rates Wednesday, a poll from debt advisors MNP shows rising concern over higher rates.

The survey, conducted by Ipsos, found that 1 in 3 Canadians are worried that rising interest rates could push them towards bankruptcy, up 6% since June.

More than half (52%) of respondents said that they are concerned about affording their debts as rates climb, that’s up 3% since June.

The share of those who say they are feeling the effects or recent rate rises; and the share who say future rises could put them in financial trouble; both hit 45%.

Almost two thirds of both Millennial and Gen X respondents are concerned about the impact of interest rate rises on their ability to service debts, while Boomers are less concerned (40%).

The poll reveals that 80% will cut back on spending to counter the effects of rising rates and there is some optimism about debt situations with 28% saying theirs has improved in the past year, 39% expecting improvement in the next year, and 50% saying improvement will be within 5 years.

Two in five said they regret the level of debt they have.

Albertans (20%) are most likely to say their current debt situation is worse, followed by residents of Atlantic Canada (17%), Saskatchewan and Manitoba (15%), Ontario (13%), Quebec (10%), and British Columbia (8%).

Quebec residents (49%) are most likely to rate their personal debt situation as good, followed by residents British Columbia (45%), Ontario (38%), Saskatchewan and Manitoba (34%), Alberta (33%) and Atlantic Canada (28%).

Homeowners could be facing two interest rate rises in the coming months according to an updated forecast.

CIBC Capital Markets said Thursday that it was already expecting a rate rise in October due to anticipation that a NAFTA deal would happen. The agreement of the next-gen trade deal USMCA supports the earlier forecast.

However, economists are now calling for a further rate rise in January 2019, slightly earlier than it had been forecasting. That’s due to recent positive data points.

The good news for homeowners with mortgages is that, following those two rate rises within three months, CIBC Capital Markets believes there will need to be a “prolonged pause” by the BoC due to the “elevated sensitivity of households” to the interest rate hikes.

The outlook also forecasts that the Canadian dollar will strengthen over the next six months or so before easing back to the low 1.30s against the greenback by mid-2019.

Challenges ahead for the economy

CIBC economists Andrew Grantham and Royce Mendes have posted their economic outlook for the coming years and highlighted some challenges.

These include rising mortgage rates, attracting and retaining talent, and a US slowdown by 2020.

Provincially, Alberta is expected to see stronger growth in 2018 than previously predicted due to a resurgence of oil production.

BC is set for weaker growth than expected due to the slowdown in the housing market, which is a key driver of growth in the province. The economists note that there has been a more pronounced slowdown in the BC housing market activity than in Ontario and not much of a rebound so far.

The outlook also suggests a slowdown in consumer spending in BC and Ontario as the provinces see the biggest impact from rising interest rates.

The report highlights that 5-year mortgages will be renewed at higher rates for the first time in a generation.

Interest rates could hit 6% by 2020, according to Moody’s Analytics.

The prediction, using RPS data, is based on policymakers realizing plans to quell housing bubbles in Toronto and Vancouver, as well as on rising interest rates.

“Two macroeconomic projects now dominate housing markets in Canada,” said Andres Carbacho-Burgos, a Moody’s economist. “The first is that the [Bank of Canada] will continue to tighten short-term interest rates through 2020 in order to head off inflation and also maintain the value of the Canadian dollar relative to its U.S. counterpart.

“With some lag, monetary tightening will pull up mortgage rates. The five-year mortgage rate is now at about 4.4% after bottoming out at 3.6% in mid-2017; the Moody’s Analytics baseline projection is that it will continue to increase until it levels off at about 6% in late 2020.”

Prolonged North American Free Trade Agreement negotiations have only deferred the Bank of Canada’s rate hiking mandate, but with the federal government this week finalizing a new deal, the United States-Mexico-Canada Agreement, there will almost certainly be a hike on Oct. 24.

“Overall, when it comes to the new USMCA, it’s going to affect the housing market because interest rates are bound to go up,” said Samantha Brookes, founder of Mortgages of Canada. “The Bank of Canada was holding back the rate until there was an agreement. Now, we’ll get increases based on the way the economy has been performing, and what that means for Canadians is interest rates will go up and prices will continue to adjust.”

That will likely make conditions favourable for buyers as the market continues recovering from the shock of so many changes.

“I believe it will probably take until 2020 until we see some light at the end of the tunnel,” she said. “But that’s based on the correction that’s been happening over the last year. People need to be more creative with how they’re purchasing.”

This could give further rise to co-ownerships in the housing market.

“It’s becoming more and more popular,” said Brookes. “Be creative and you’ll still be able to get in. We all know real estate is still the number one investment, and it will be time to hold onto that investment rather than flipping it for a quick buck. It’s too risky for that right now, so buy and live in your home for a few years until the market corrects.”

The Conservative Party of Canada will make B-20 a hot button issue during next year’s election.

The party’s Deputy Shadow Minister for Finance has already tabled two motions, both of which were rejected by the Liberals, to study B-20’s effects. Refusing to go quietly, MP Tom Kmiec has vowed to put the mortgage stress test back on the agenda in time for the Oct. 2019 federal election.

“It will be an election issue, absolutely,” Kmiec told MortgageBrokerNews.ca. “I’m willing to use procedural tools to get this study done. I’m not necessarily saying to get rid of B-20 completely; I’m saying take a look at the data and then make a decision on it. I’m asking the Liberals to provide any internal documents they have showing why the mortgage rules were introduced in the first place.”

With the Bank of Canada raising interest rates, mortgage qualification has become even more onerous and Kmiec says it’s only going to get worse.

“This is an affordability issue. The Bank of Canada is raising interest rates, and I don’t fault them for it, but rules like B-20, and then provincial rules, are compounding and making it unaffordable for young people to get into their first home,” he said.

“There was a 63% jump in mortgage originations among 73- to 93-year-olds in the first half of this year, which is unusual for the pre-war generation to suddenly take out a whole bunch of mortgages for no apparent reason after B-20 was introduced. It only makes sense when you notice that mortgage originations among millennials are down 19% and Generation Z mortgage originations are down 22%. Are the B-20 mortgage rules causing Canadians to go to their grandparents to take out mortgages for them in their names?”

If that is indeed the case, Kmiec notes that, in the event of a grandparent’s death, messy estate complications will ensue.

According to Victor Peca, a mortgage broker and founding partner of Monarch Mortgage Group, the Liberal Party has deluded itself into believing B-20 is impacting the country positively. However, that isn’t the worst of it.

“The B-20 rules aren’t working because I see a lot more deals coming to me with fraud,” said Peca. “B-20 isn’t stopping that; it’s making it more pronounced because it’s harder to get a mortgage. When someone wants to buy a home, they’ll do whatever it takes to get that picket fence.”

Kmiec has started a website to pressure the Liberals into studying B-20’s effects. He claims the Liberals told him B-20 wouldn’t be examined without more data, which he says has since become plentiful. Having participated in filibustering the electoral reform committee, the Liberals might have underestimated Kmiec’s resolve, not to mention indefatigability.

“If it comes down to it, I’m happy to use up every two-hour time limit on every single committee until we agree to do a mortgage study,” said Kmiec. “I’m not asking for the moon, either. All I want are a few meetings in Ottawa where we can invite people with data who can then tell us what’s happening with the market.”