Philippe Miller, Global Capital Markets Associate
For most of 2022, the Bank of Canada has been ahead or not far behind the Federal Reserve in terms of policy rate. It was strategic enough to raise rates at their own pace throughout the year while closely watching the spread between both overnight lending rates. With a standardized rate hike expected from the BOC on December 7th, this spread will narrow back to par until December 14th, where the Fed will most likely hike by 50-bps and widen the spread to half a point. This will be the largest divergence in overnight rates between both countries since August 2019.
With the terminal rate forecasted between 5.00-5.50% in the US vs. 4.25-4.50% in Canada, this spread will potentially increase to 100 bps and hit a multi-decade high in 2023. It is worth wondering why the Bank of Canada cannot follow suit with their neighbors down south.
Firstly, despite positive economic outputs above 3.0% in 2022, Canada’s labour market has been volatile and remains fragile. Canada’s employment change has been bumpy with sharp losses due to Omicron back in early January 2022, while the October data surged 10-fold higher than expectations. On the American side, the US has not seen job losses since December 2020. The US labour market has proven to be growing ever since the mist of the pandemic lifted and is only starting to slow down now. This strength is closely monitored by the Fed which models how the American consumer would be impacted by higher borrowing costs. As the risk of a slowing job market is higher in Canada than in the US, the Bank of Canada has no choice but to take this into consideration when implementing their monetary policy.
Secondly, Canadians are more exposed to interest rate fluctuations. For comparison, about 10% of all US mortgages are variable-rate mortgages whilst more than one-third of all Canadian mortgages are variable. This is significantly higher and has increased from 19% to 33% between 2019 and 2022 as rates were at historical lows during the pandemic.
According to the Bank of Canada, 75% of those mortgages have fixed payments, meaning that when interest rates move, the amount of the mortgage payment does not change. However, the allocation to pay the principal will be reduced as the portion towards the interest is adjusted higher. With the Canadian prime rate already at 5.95%, about 50% of all variable-rate mortgages with fixed payments have already reached their trigger rate. The trigger rate is attained when the entire mortgage payment is allocated to pay interest, with no amount paying down the principal. With an additional 25 to 75 bps expected by early 2023 in Canada, another 15% will hit their trigger rate. This is where the pain arises. Depending on how low the rate was when the mortgage was issued, the increase in payments can range between 5% to 20%. With such a high proportion of Canadians at risk, the BOC cannot ignore this.
Thirdly, the average Canadian is more leveraged compared to the average American. According to Q2 data, the Canadian household debt to income ratio stands at 181.66, the second highest level on record and almost doubled the US’s ratio of 100.74.
As these risks could plunge the economy into a recession, the central bank has no choice but to consider all factors before raising rates higher. Could this mean that Canada is at the mercy of a downturn in 2023?
Only time will tell. One thing is sure, Canadians will need to be careful. Winter is coming.
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