Bank of Canada Rate Hikes: Will Cool CPI but not in 2022; No Dice on Hot Housing

Canada’s Consumer Price Index - supposedly our best benchmark of inflation - is at 4.7%, far above target levels of 2% and the worst it’s been in two decades. Unfortunately, actual inflation is much higher. While it’s difficult to find a consensus or definition for what “actual” inflation is, certain numbers highlight gaps in the Statistics Canada methodology for calculating CPI. For example, StatCan does not track used vehicle prices, a major indicator of inflationary pressure, which in 2021 jumped by 38% in Canada compared to 31% in the U.S. Another example is the price of food. According to StatCan, food prices are up 2.7% over the past 12 months, whilst independent research, such as Dalhousie University’s Agri-Food Analytics, show estimates closer to 5%. And then, of course, there’s the elephant in the room: Canadian real estate. The StatCan approach does not price in the expected appreciation of owner-occupied dwellings, making it hardly reflective of hot housing prices across Canada, which as of November 2021 are up an average of 20% from the previous year.

Despitearticle by Daniel LeCalle, in the context of the Evergrande crisis, points out that:

“No economy has been able to ignore a property bubble and even less so offset it and continue to grow, replacing the bust of the real estate sector with other parts of the economy…. Heavily regulated economies from Iceland to Spain have failed to contain the negative impact of a real estate sector collapse".

Although in these examples the average size of the sector was closer to 15-20% of the country’s GDP, the consideration isn’t whether the Canadian housing market is too big to fail. The far more important question is whether the Bank of Canada believes the Canadian housing market is too big to fail. And that’s an easy one to answer.

The Bank of Canada would certainly seek to stave off a decline in housing prices in order to protect overleveraged Canadians and the real-estate reliant economy. In early 2020, when the impact of the pandemic on Canadian real estate was not yet entirely clear the Bank of Canada began purchasing billions’ worth of Canadian Mortgage bonds, injecting the mortgage market with liquidity to lower mortgage rates even further and stave off a potential pandemic-driven downturn in housing. Between March 2020 and the end of October 2020, the bank of Canada purchased $9.601 billion worth of Canadian Mortgage Bonds - a nearly 1,750% rise from the same week the previous year. Retrospectively, the BoC’s CMB shopping spree proved either highly successful or entirely unnecessary.

The period between 2017- 2018 provides another example of the BoC’s direct intervention to prevent a downturn in housing prices through CMB purchases. In 2017, a combination of higher interest rates, Chinese capital controls, and the aforementioned 12% speculative buyer tax led to single-family homes falling ~12% in both Toronto and Vancouver. Increasingly concerned about overleveraged buyers and household debt vulnerabilities, the BoC began injecting millions into mortgage liquidity through the purchase of Canadian Mortgage bonds, which had the effect of lowering mortgage rates, and successfully reinvigorating home sales and values in 2018.

Investor Takeaway: Is Canadian Real Estate still a solid investment?

Although the aggressive rate hikes now anticipated from BoC and the Federal Reserve (which also impacts Canadian mortgage rates) will cool speculative buying and domestic investor activity, there’s not much that monetary policy can achieve if foreign demand remains robust. While the Bank of Canada may have helped create, and has certainly at times helped artificially inflate property prices, it may be beyond its capability to now help tame the beast it helped birth.

Whilst government policy has maybe cooled housing price in the past (i.e in 2017 with the speculative buyer’s tax), the current government’s response to the issue so far is likely to be ineffective: the newly introduced 1% Underused Housing tax on the value of non-resident, non-Canadian owned residential real estate will be small game to investors who are willing to pay up to millions of dollars over asking price to move or invest their wealth into prime Canadian Real estate. If government policy were enacted to cool housing prices, it’s hard to see the BoC standing by to allow a downturn in housing and its fallout on uninsured and overleveraged Canadians, particularly as levels of household debt, and vulnerabilities have worsened since 2018 when the Central bank felt compelled to intervene and prop up the property market. The percent of uninsured and highly-leveraged mortgage holders has increased from approximately 14% in 2018 to 25 % in early 2021.

Canadian housing prices are unlikely to cool to a point where income to house price ratios return to levels similar to the U.S. or even narrow significantly. For the foreseeable future, Canadian housing will be far more expensive than comparable real estate in the U.S., and likely even more unaffordable than it already is. With little change to demand fundamentals, housing prices are unlikely to normalize. The unaffordability of housing is likely to remain a standard feature in Canada. Perhaps disheartening news for the approximately 30% of Canadians who do not own their own homes, but good news for homeowners, and still a solid opportunity for investors in Canadian real estate and REITs, many of which remain undervalued and a strong buy for 2022 despite outperforming housing growth in 2021.

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Written By: Investing.com