Market-implied policy tightening could topple housing

The surge in interest rate expectations is a key risk to housing. We recently set out how, due to the much larger share of variable rate mortgages than before the pandemic, the Bank of Canada would need to raise its policy rate to 2.5% to achieve the same average mortgage rate on new borrowing as when the policy rate peaked at 1.75% in late-2018. Following the sharp move in the past two weeks, that is exactly what markets are now pricing in for next year. The question, therefore, is can the housing market withstand a return to pre-pandemic mortgage rates, even though prices have risen by more than 50% in the interim? The answer is a firm “no”. Based on our forecast that the policy rate will peak at 2.0%, we expect house price inflation to slow to little more than zero next year. An even higher policy rate could trigger house price declines. Admittedly, we shouldn’t assume that the Bank wants to avoid house price declines at any cost. House prices are a key driver of shelter inflation, so moderate declines would help to get consumer price inflation under control without seriously jeopardising the economy. But with house prices now so elevated versus traditional valuation metrics, the risk is that an initial decline could trigger a downward spiral of lower house prices and lower house price expectations.