What the data really says.
Jun 13, 2013 Larry MacDonald Canadian Business
Earlier this week, some Canadian banks hiked the fixed rate on their five-year mortgage term by 20 basis points to 3.29%. Not surprisingly, housing bears are proclaiming that mortgage rates are now in an uptrend that will collapse the housing market. While we may be headed into an era of heightened volatility, I’m still not convinced the bell is tolling. Here are some reasons why.
1. Fixed-mortgage rates ticked up this week because they are priced off bond yields and the latter have been moving up as signs mount that the North American economy is gaining traction (leading to the Federal Reserve hinting that it may need to wind down its monetary stimulus). But when the economy lifts off into a self-sustaining phase, employment and income growth will also be gaining momentum—which, in turn, will offset the adverse impact of rising interest rates on house prices. There is nothing unusual about this dynamic: it appears regularly in the history of business cycles.
2. Empirical data does not support the thesis that higher mortgage rates inevitably translate into lower house prices. In fact, a study of monthly housing data from 1980 to mid-2010 by mortgage specialist David Larock found that the majority of rate increases in Canada did not lower house prices.
3. It is still an open question whether or not an uptrend has begun in mortgage rates. Usually more than one increase is required to make that call. But if an uptrend is beginning, it’s worth noting that variable-rate mortgages remain tied to the Bank of Canada’s lending rate—and it will not be adjusted upward until the housing market is able to take it in stride.
4. History shows that the initial rounds of increases in mortgage rates are actually bullish for the housing market because people mulling a house purchase are given a nudge off the fence. There is anecdotal evidence for this already: for example, as Rob McLister, editor of CanadianMortgageTrends.com, tweeted June 3: “Multiple lenders are reporting high application volumes [due to] people trying to beat rate increases.”
5. There is a fair amount of pent-up demand on the sidelines that could be encouraged by higher mortgage rates to enter the market. As industry insider, Ann Hannah, told the Globe and Mail recently, “a growing number of households who put their decision to purchase on hold as a result of stricter lending guidelines are starting to become active again in the ownership market.” In addition, some of the people who have been renting or living with parents in hopes of buying a home at a lower price may be getting married, having kids, receiving salary increases, or otherwise simply deciding they can’t wait any longer.
6. If a rise in mortgage rates is beginning, the Canadian market has a much greater capacity to absorb it than the U.S. back in the 2000s. About 70% of mortgages in Canada are currently fixed-rate mortgages and most of those are for five-year terms. This means rate increases will feed into the market slowly since only a portion of these mortgages come due every year. Just before the U.S. housing crash, about 75% of mortgages in that country were on variable rates and the Federal Reserve was aggressively driving them up. Lastly, a recent National Bank Financial study found only 7% of borrowers under CMHC’s mortgage insurance program had low credit ratings, compared to 28% in the U.S. at the end of 2006.
7. The rate increase announced this week was for published rates. It is still quite supportive, and discounted rates are even lower, near 3% on the 5-year term. Furthermore, it would not be surprising if published rates lagged increases in bond yields (and/or discounted rates lagged published rates) for the reason mentioned in Tim Shufelt’s “The incredible shrinking mortgage rate.” As he writes: “a slowing housing market puts even more pressure on the banks to cut their [profit margins] as they battle for share in a dwindling market.”
8. True, there may come a time when the economy becomes overheated and the Bank of Canada needs to tighten. But that is far off in the future. And presumably, policymakers will be sufficiently chastened by what happened in the housing-meltdown countries to be more circumspect about precipitating housing busts. Finally, ongoing growth in incomes, along with the government’s tinkering with mortgage rules to keep a lid on prices, should have by then brought valuation down to safer levels.