The Tipping Point

Once again, the market held its breath while waiting for the Bank of Canada’s (BoC) latest rate decision. The BoC’s approach is quite different to the communication philosophy adopted by the Fed during the Chairmanship of Ben Bernanke – aiming to better manage market expectations and to avoid “surprises” which in the past have resulted in market volatility.

While several economists and experts foresaw the BoC raising its overnight rate, going into the June 7th meeting, the rate hike was given a 40% probability by market participants. The BoC seems to have concluded that, on balance, the health of the economy provided enough leeway to tackle stickier than expected inflation by raising rates by a quarter of a percentage point.

In our view, however, the Canadian economic situation remains fundamentally quite distinct from that of the US or the EU with specific (elevated) risks inherent to it. This latest rate hike, and any potential future increases, will further exacerbate the effects of these risks on the economy.

In particular, there are two specific sources of risk to the Canadian economy:

1. Canadian households are very leveraged.

The debt to disposable income ratio of Canadian households is now at 180%. This vastly exceeds that of households in the US at 100%. Even when this is adjusted for differences in methodology and other considerations, households in Canada have higher debt levels relative to income than their US counterparts prior to the Global Financial Crisis of 2008.

This means that, as the cost of servicing their debt rises, Canadian households will be under increasing pressure and will be forced to make choices by redefining their spending priorities and reshaping their spending habits. Anecdotal evidence of this is already available, such as families choosing to reduce their children’s extra-curricular activities or to modify their food purchase baskets.

2. Mortgages

Variable mortgages represent 40% of Canadian outstanding mortgages and fixed-rate mortgages in Canada usually have a maximum duration of 5 years. This pales in comparison with the US and EU where mortgages could have been locked in at very low rates for 20 or 30 years back in 2020 and 2021.

As we enter a second year of higher long-term rates, mortgage holders will come under pressure in one of two ways:

• Variable mortgages will reach “trigger” levels. This means that fixed, monthly or bi-weekly payments no longer cover the interest payments, and mortgage holders will be required to increase their installments. This has likely happened for nearly 40% of mortgage holders. In January 2023, we estimated that additional cumulative hikes of 75bps could result in nearly 80% of variable holders having to increase their installments.
• As fixed-rate mortgages keep maturing, and mortgages agreed at lower rates come due, mortgage holders will face new rates that are noticeably higher and corresponding installments that will substantially increase.

So far it seems that Canadian households have managed to cope with these trends by modifying their spending habits. This is in great part due to a healthy employment picture.

But what if these changes (and often reductions) in spending were to impact the resilience of the employment market? The most recent employment data published in June recorded a small loss in employment but more importantly saw the first rise in unemployment in nearly a year, rising to 5.2%. While one cannot infer a shift in trends based on a single data point, it should be a reminder that the combination of high leverage, low savings and deteriorating employment can be particularly concerning.

This combination – should employment soften further – is a Canada-specific situation as both the US and EU have less leverage and higher saving rates. In other words, in its quest to fight inflation, the BoC has markedly different initial conditions than other jurisdictions.

Admittedly, the BoC seemed well aware of this when it decided to pause hiking in April. However, in our view, the recent hikes could lead to a situation close to tipping point. In fact, any further hikes might result in negative economic effects and downsides that are often hardly measurable given the abrupt and discontinuous nature of the default mechanism in a high leverage environment – a mechanism that unfortunately can create a negative feedback loop.

As such, it is key to remain alert to any signs of such developments in Q4 of 2023 and beyond.