"We Know It's Going To Be Painful": Half Of Existing Canadian Mortgages Are Up For Renewal In 2018

When commenting last week on the latest troubling trends in Canada's housing market, we predicted that unlike a previous forecast by Deutsche Bank's Torsten Slok from early 2015, who at the time said that "Canada is in serious trouble", this time the moment of truth for Canada's all important housing market was indeed at hand.

The reason?

While it had taken banks some time to push up their mortgage rates, they were finally "catching up" and as Bloomberg reported, just in the past few days Toronto-Dominion Bank - Canada's second largest lender - lifted its posted rate for five-year fixed mortgages by a whopping 45 bps to 5.59% as government bond yields touched their highest levels since 2011 this week.

"It’s a big move, the biggest move in years," said Rob McLister, founder of RateSpy.com, a mortgage comparison website.

As regular readers are well-aware, rising rates in Canada has often been cited as the catalyst that could and would burst the country's housing bubble, because Canadian households, unlike American ones, never managed to delever...

... and even modest increases in rates would have adversely cascading effects.

And while Toronto Dominion was not alone in raising key borrowing rates last week - it was joined by all of Canada's biggest banks - just as the busy season for residential real estate gets underway, a more troubling development is taking place in the mortgage market, which according to Bloomberg is set for a particularly heavy year of renewals in an environment where debt-servicing costs are already soaring at the fastest pace in a decade.

What happens next is anyone's guess, but the answer is critical as it will determine the severity of the recession that is now virtually assured to hit Canada.

“The economy has never been as levered as it currently is, and the economy is far more interest sensitive than it has been in the past, to a degree that we don’t have certainty over how each interest rate hike is going to affect Canadian consumers,” Frances Donald, senior economist at Manulife Asset Management, said by phone from Toronto. “All we know is it’s going to be painful, but how painful isn’t quite clear.”

As Bloomberg notes, the heavy household debt burden is perhaps the key reason the central bank has been reluctant to raise borrowing costs further, after hiking interest rates three times between July and January. Given the nation’s debt load - as of February, households had a record C$2.1 trillion ($1.6 trillion) of mortgage and non-mortgage debt - Poloz estimates the economy is 50% more sensitive to rate hikes than at any time in the past.

And yet, the banks appear to have capitulated last week when one after another they all hiked key mortgage rates in rapid succession, akin to the infamous selling scene in the movie "Margin Call": the bank knew it would launch a financial crisis by being the first to sell as it would force the world to finally admit the emperor was naked.

Now it is Canada's turn.

And here's why Canada will no longer be able to avoid the troubling reality of rising rates: the country is entering a period in which no less than 47% of existing mortgages need to be refinanced this year versus 25% to 35% typically, according to Ian Pollick, head of North American rates strategy at CIBC in Toronto.

Worse, the refis will take place smack in the biggest mortgage interest increase in over a decade, just as the country’s biggest banks are raising key mortgage rates. To be sure, as we reported last week, Toronto-Dominion kicked it off Thursday, hoisting its five-year fixed mortgage rate 45 basis points to 5.59 percent. Royal Bank followed with its own hikes Friday.

Even worse, new mortgage stress tests are pushing some borrowers from the big banks to alternative lenders charging higher rates. Lenders such as the infamous Home Capital Group, which only survived a furious bank run thanks to a last minute bailout by Warren Buffett.

“That’s an unfortunate outcome of the stress test,” Will Dunning, an economic consultant who specializes in the housing market, said by phone from Toronto. “In that sense, the stress test is not reducing risk. It’s increasing risk.”

No matter who they refi with, the pain for Canadian homeowners appears unavoidable. According to Statistics Canada, total payments on debt made by Canadian households rose 6.7% in the fourth quarter from a year earlier, and the interest-paid component climbed 9.2%. Those were the biggest gains since the financial crisis.

A moving average of quarter-over-quarter changes shows a similar pattern, with the 1.62% increase in the latest period the fastest since 2008.

Meanwhile, as shown in the top chart, debt payments now represent about 14% of household disposable income, the highest share in three years: as long as rates keep rising, debt-service ratios will continue moving higher as well over the coming quarters, until a tipping point is reached, and there is a wholesale interest payment revulsion.

“The world spends a lot of time talking about the level of Canadian debt being extremely elevated, but what matters most is not the level of debt that Canadians hold, but the cost of carrying that debt,” Manulife's Frances Donald said. She's right, and the problem is that the cost of carrying that debt is now spiking.

Canadians are going to start to feel the pinch” Donald added ominously.

To be sure, as we reported three weeks ago, the cracks are already appearing: as RBC analyst Vivek Selot pointed out, the roll rate - the percentage of credit card users who “roll” from early stage delinquencies to 60-89 day delinquencies - reached the highest since 2008 for one credit card program, while delinquencies for another were above the 10-year average.

And while the level of mortgage arrears is still low by historical standards, a rising debt service ratio could signal that’s about to change.

The big question, of course, is what happens if and when the economy - which has never been more levered - falls into an all out recession. Perversely, Canada’s economy led the G-7 in growth last year, mostly because of the willingness of the country’s consumers to spend money, much of it on even more (cheap credit). But growth is expected to slow this year; GDP shrank unexpectedly in January, with February due latest Tuesday. Another disappointment, and that may be it for the BOC's tightening cycle.

Meanwhile, leading indicators suggest that the tipping point may have already come:

Canada's retailers have already had a tough few months. Retail sales in February were still 1.8% below 2017 peak levels. In volume terms, the input used to calculate gross domestic product data, first-quarter retail sales probably posted the biggest quarterly drop since the 2008-09 recession.

Canada bulls hang their hat on the country's still low unemployment rate, which has benefited from rising oil prices,  and decent economic growth which should help the economy weather higher rates, although with ever basis point increase, risks are rising.

“You have some capacity in the economy to absorb this, but the fact that rates are going up isn’t positive for consumers, because it’s making credit more expensive,” Bloomberg Intelligence analyst Paul Gulberg said “That’s the but”, and in an economy that has never been more in debt, that is a very big 'but'.