Yesterday, the Bank of Canada made a historically big move, hiking its trend-setting interest rate by 0.5% -- the second consecutive such increase -- bringing the official cost of borrowing to 1.5%. It was only the fifth time in the central bank’s existence that it made such a large one-time increase, as it typically tweaks its policy rate by quarter-point increments.
The BoC is embarking on such an aggressive hiking mandate in an effort to tame runaway inflation growth, which hit a the three-decade high of 6.8% in April, and is expected to increase further in the months to come. However, it's increasingly hawkish stance indicates there are more bold moves to come -- and that will put additional pressure on borrowers.
“The 50 basis points was the worst-kept secret. That wasn’t the surprise, it was actually some of the commentary,” Jordan Damiani, Senior Wealth Advisor at Meridian, tells STOREYS.
“There are actually two verbatims that I picked out. One was that the Bank of Canada said that they were ready to act ‘more forcefully’ -- so that was one thing that would potentially [suggest] the pace of rate hikes could still be even more aggressive than is projected. The other one that I think is really relevant to a lot of Canadians is their comment that they felt that housing prices were at ‘exceptionally high’ levels… That’s partly why we’re seeing these really aggressive rate hikes up front, is just to slow the economy, slow housing, to combat inflation.”
Indeed, chatter has been growing louder that the BoC’s strong policy language could spell a 0.75% increase in its next policy announcement, scheduled for July 13. In a note to investors, Bank of America Securities economist Carlos Capistran, wrote that, “We believe the Bank of Canada clearly wants to move fast to the two to three per cent neutral range. So a 75 [basis point] hike in July is a very real possibility, in our view.”
However, Damiani isn’t so sure that they’ll take such a dramatic approach, pointing to similar speculation around the U.S. Fed’s monetary policy direction. “They came out fairly recently saying they were comfortable with 50-basis-point rate hikes, so I think the base case is probably still 50, with an upside surprise of 75,” he says. “And I think the one thing we can be certain of is the pace is still going to be fairly aggressive, there’s probably no 25-basis-point chance at the next meeting.”
Borrowers Already Feeling the Squeeze
Robert McLister, Mortgage Strategist at MortgageLogic.News, says that while the bond market is pricing in no more than a 50 basis points hike next month -- at least for now -- it’s signalling a good chance the BoC will hike to 3% by the end of then year, resulting in a 5.20% Prime rate from consumer lenders.
The impact of such a rapid hiking cycle is already being keenly felt by borrowers, he says. According to his calculations, a borrower taking out a new variable-rate mortgage on the average Canadian home could expect to pay $3,354 per month, compared to the $2,386 they would have paid in January.
“A Canadian making an average income simply cannot absorb a $968 per month payment difference,” he says. “Statistically speaking, average Canadians can no longer afford the average home with a traditional mortgage; the only way someone making $100,000 a year can afford the average home with 20% down is with a higher-cost alternative non-bank mortgage.”
While variable-rate borrowers won’t see any change to their monthly payments -- the difference instead impacts the amount of their payment going toward their principal, and potentially their amortization -- those with floating-rate products are directly exposed to the recent surge in Prime, which rose to 3.7% upon the Bank of Canada hike. As of today, the typical big bank variable discount had dropped to prime - 0.55%, down from prime - 0.95% at the beginning of the year.
Damiani adds that many existing borrowers holding a long-term position in housing are likely to ride out the volatility, but those who bought at the start of 2022 are likely feeling the immediate squeeze, along with absorbing a paper loss from the recently softening market.
“You look at the average Canadian homeowner, and you have a slice that’s affected today and a slice that might not feel great, but might not see an immediate impact,” he says. “Just to speak to anyone that bought at the peak of the housing market; they’re probably not happy in terms of, on paper, what’s happened with housing prices, but they’ve likely in most cases, locked into a fixed-rate mortgage. Their concern isn’t so much that their cost of borrowing is going to increase, it’s, what’s going to happen when that mortgage comes due, and then maybe rates are substantially higher at that point.”
One way borrowers can help insulate themselves from a rising rate environment is by stress testing their finances ahead of making a home purchase, he says. “Can you absorb the impact of higher variable rates going forward, not just in a variable-rate mortgage, but there’s a lot of debt on Home Equity Lines of Credit as well, and that debt is going up, too.”
Will OSFI Ease the Mortgage Stress Test?
Of course, the BoC’s latest hike has stoked fresh expectation that OSFI, Canada’s banking regulator, will react by tweaking the mortgage stress test, which has been criticized for becoming too stringent as the cost of borrowing rises. Currently, borrowers of new mortgages must prove they can carry their mortgage at a rate of 5.25%, or their contract rate plus 2% -- whichever is higher. Previously, the vast majority of borrowers would find themselves tested at the plus-2% threshold, but as rates spike, they’re now facing testing in the 6.4% range, says McLister.
OSFI’s Deputy Superintendent of Supervision Ben Gully stated in May that the banking regulator could be considering a review of the stress test’s criteria, given how dramatically borrowing conditions have shifted in recent months.
“Frankly, OSFI's stress test formula makes no sense. They should have qualified all mortgages at the typical five-year rate plus 200 bps like the government originally proposed,” McLister says. “I expect them to fix this stress test bias soon.”