It is no surprise to anyone that the Bank of Canada maintained its target overnight rate at 1/2 percent today, judging that the underlying trend in inflation continues to be about 1.5 to 1.7 percent. Even before the landslide sweep of the Liberal Party into power, assuring a more stimulative fiscal policy next year, the Bank was widely expected to stand pat for the foreseeable future.
The Monetary Policy Report (MPR), released today, was written before the election results were known and its economic projections do not reflect the impact of the Liberal Party fiscal proposals. The Liberals will introduce a more proactive fiscal policy, reducing the reliance on monetary policy to do all of the heavy lifting in boosting economic activity. The Liberals won on the platform of running budget deficits over the next three years to boost economic growth, which has been languishing despite repeated reductions in interest rates.
The Bank of Canada now estimates third quarter growth to have been roughly 2.5 percent with a slowdown to 1.5 percent growth in the current quarter. This would put this year’s real GDP growth at a mere 1.1 percent–well below the 2.4 percent pace last year and underperforming the growth in the U.S. by a wide margin. Canada’s economy has been hit hard by the massive decline in oil prices. But, as well, Canadian exports are no longer as sensitive to an acceleration in U.S. growth as they once were, largely reflective of the contraction in the relative importance of the Canadian automotive sector.
The Bank has revised down its forecast of global growth in 2016 and 2017. For Canada, the Bank says that “lower prices for oil and other commodity prices since the summer have further lowered Canada’s terms of trade and are dampening business investment and exports in the resource sector. This has led to a modest downward revision to the Bank’s growth forecast for 2016 and 2017.” Before taking any additional fiscal stimulus into account, the Bank now projects real economic growth to be 2.0 percent next year and 2.5 percent in 2017.
It is my view that growth will exceed these forecasts by as much as 0.5 percentage points owing to the likely mix of government spending increases and middle class tax cuts, although the details and timing of these actions are yet to be nailed down. In consequence, the Bank of Canada easing cycle has ended and rightly so. The Bank has run out of bullets with overnight interest rates so close to the zero lower bound. The Bank will stand pat for at least the next year regardless of U.S. Federal Reserve action. The Fed is widely expected to start liftoff in the next few months.
Thus, Canadian interest rates have bottomed. Most particularly, mortgage rates have bottomed. The growth in mortgage lending has likely peaked, or will very soon. Bank of Canada data show that the growth in the number of mortgages has slowed this year, although dollar volumes continue to accelerate owing to house price increases. With 70 percent of Canadian households already owning their own homes and housing affordability declining with the bottoming in mortgage rates and the rise in house prices, lending activity will inevitably slow as will the rise in the price of homes, which has continued strong in Vancouver and Toronto, particularly in the single-family sector.
This is a good thing, particularly since the slowdown will be gradual and measured. We will not experience a housing crash as some Cassandras have predicted for decades. We will, however, see a slowdown in the pace of house price appreciation, especially for the condo sector, where overbuilding is most evident, unsold vacancies have risen, and–perhaps, most importantly–a pick-up in the construction of rental housing is in train in Toronto. Rental vacancy rates in Toronto and Vancouver are extremely low–roughly 1-1/4 percent–despite the enormous increase in condo construction in recent years and record investor-held condo rental supply. Single-purpose rental construction has been all but dead for decades in both cities given rent controls and other restrictions.
However, currently, demand fundamentals are so favorable and capital availability from major institutional investors is so rich that there is a burgeoning sea change in rental construction. Developers and institutional investors are turning to the rental market for new opportunities. According to media reports, the number of new apartment units under construction in Toronto is hitting a 25-year high. Urbanation Inc., a real estate research company, reports that there were 26 apartment buildings under construction in the Toronto area in the third quarter. Developers have proposed another 43 rental buildings containing more than 10,000 units. Reports also suggest that developer and investor interest in rentals is also nascent in Vancouver, Montreal, Calgary and Ottawa. More specifically, the Globe and Mail reported on October 15th that:
“Riocan Real Estate Investment Trust, one of Canada’s largest retail landlords, has one rental building under construction as a joint venture in uptown Toronto and is proposing to build six more. Insurance companies Great-West Life Assurance Co. and Sun Life Financial Inc., along with Cadillac Fairview Ltd., the real estate development arm of the Ontario Teachers’ Pension Plan, and private equity firm KingSett Capital are all either building or proposing new rental construction in the city.”
The high price of homes is pushing people into the rental market and as the cycle of extremely low and declining mortgage rates ends, more people will rent and do so for longer. Land and construction costs are now rising faster than the price of new condos, providing the economic backdrop for a coming slowdown in condo construction and improving fundamentals for rental markets.
Make no mistake, I am not suggesting that mortgage rates will rise rapidly or that a U.S.-style housing and mortgage crisis will occur. Canadians are not subprime borrowers and household balance sheets for the majority of homeowners are rock solid. Having said that, however, roughly 10 percent of Canadian home-owning households have high enough debt servicing costs relative to income that they are vulnerable if mortgage rates were to spike. The Bank of Canada has expressed repeated concern about this constituency and the lenders are well aware and cautiously prudent. I expect mortgage rates to edge up only gradually. Inflation remains quite low and Canada’s public finances are sufficiently sound to easily finance proposed budget deficits.
A gradual deceleration in condo appreciation is a good thing for sustained financial stability.
