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The Bank of Canada has a stark message for Canadians: Interest rates are guaranteed to increase but home prices are not.

With the pandemic’s low interest rates pushing over-leveraged borrowers to pile on mortgage debt, the central bank ranked household indebtedness and accelerating home prices among the biggest threats to the economy in the medium term.

The average home price in the country has jumped more than 30 per cent during the health crisis, with prices climbing at a faster pace in the Toronto suburbs and smaller Ontario cities. The bank itself has played a role in stoking demand for real estate by holding interest rates at record lows over the past year, and promising not to raise them for some time.

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Bank of Canada warns carbon-intense assets are mispriced

Bank of Canada ready to respond if high inflation becomes persistent, Macklem says

“Some people may be thinking that the kind of price increases we have seen recently will continue. That would be a mistake,” Bank of Canada Governor Tiff Macklem said at a news conference on Thursday. “Interest rates are very low. That means there is more potential for them to go up.”

In its latest Financial System Review, the central bank warned that household vulnerabilities have intensified with the quality of borrowing deteriorating and speculative buying increasing. The bank found that the share of highly indebted households taking out mortgages is up significantly and now represents 22 per cent of all new mortgages.

That is higher than during the 2016-2017 real estate boom, when spiking mortgage debt triggered stricter lending rules from Ottawa. In addition, highly indebted borrowers are making down payments that are less than 20 per cent of the purchase price of the property. The bank said this combination has been “associated with a greater risk of falling behind on debt payment.”

“Some of the vulnerabilities that we had before the crisis have come back and top of the list is vulnerabilities related to housing and household indebtedness and they have intensified,” Mr. Macklem said. “The message to Canadians is don’t extrapolate from the current rapid increases we have seen in prices. Don’t expect that those will continue indefinitely.”

Despite the increased risks in the housing market, the central bank said that systemic risks to the financial sector remain low. Canada’s banks are well-capitalized, partly as a result of reforms taken in the wake of the 2008 financial crisis, and performed well throughout the pandemic.

As part of its financial system review, the central bank ran a “reverse stress test” to see what kind of economic downturn would be needed to put Canada’s banking system at risk. It determined that, “the Canadian economy would have to incur a severe shock – more persistent than the one experienced in early 2020 – before the capital buffer of domestic systemically important banks and their credit supply would be impaired.”

Alongside the report, the central bank introduced a “House Price Exuberance Indicator” to detect periods of “extrapolative expectations,” or the anticipation by buyers that home prices will continue to rise. Under the new measure, the Toronto region, Montreal and Hamilton are firmly in exuberant territory with Ottawa nearing that level.

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Only nine major markets were examined under the exuberance indicator. The bank included Vancouver, Victoria, Calgary, Quebec and Winnipeg, but not other regions such as Tillsonburg, Ont. and Chilliwack B.C., which have seen some of the steepest price increases over the course of the pandemic.

The bank said a misalignment of house prices and fundamentals could lead to home prices dropping in the future, which could make it difficult for homeowners to make mortgage payments or leave homeowners owing more than their house is worth.

Mr. Macklem defended the central bank’s decision to keep interest rates near zero for at least another year and repeated that monetary policy applies to the entire economy, many parts of which remain depressed.

Economists said the central bank was in a tricky position. “It’s a tough balance,” said Priscilla Thiagamoorthy, economist with BMO. “Interest rates affect so much more than just housing.”

Ksenia Bushmeneva, economist at TD, said Mr. Macklem was right to be concerned and flag the risk of high household indebtedness. “I felt that the governor has sent a strong message to Canadians, but I think the [central] bank has limited scope to play a larger role in cooling the housing market,” she said.

Very little has been done to slow the real estate boom. The Canadian bank regulator and finance department toughened up the mortgage stress test. As well, Ottawa and the City of Toronto have proposed empty home taxes to force homeowners to rent or sell their properties if they are not using them.

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Alongside housing market vulnerabilities, the bank flagged potential risks around corporate debt and business insolvencies as government support is withdrawn in the coming months.

Canadian businesses have fared surprisingly well during the pandemic, thanks to generous government support, the bank said. Overall corporate indebtedness declined and business insolvencies are 30 per cent below prepandemic levels. However, the bank warned that this could change as government support programs, such as wage and rent subsidies, wind down.

Companies that rely on high-yield debt markets to fund their operations could face particular problems if investor appetite for risky assets declines. High-yield bonds, also known as junk bonds, account for around 20 per cent of the value of all corporate bonds in Canada. Most of these are issued by commodity companies.

“A shift in investor sentiment could lead to a sharp repricing of existing assets. ... If this were to happen, it would become more expensive and difficult to roll over existing debt and issue new high-yield bonds,” the bank report said.

While the bank concluded the systemic risk to Canada’s financial system is low, there are places where vulnerabilities are increasing.

The biggest area of concern is the fixed income market, where changing patterns of bond ownership are creating “liquidity” problems in moments of crisis. (Liquidity refers to the ability of sellers to locate buyers and to transact in a way that does not cause large price movements).

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Non-bank financial institutions, including pension funds, mutual funds and insurance companies, own an increasingly large segment of the bond market. Unlike banks, these asset managers do not have capital buffers in place, or direct access to central bank funding, to meet sudden redemption requests. That means in moments of crisis, they may be forced to sell a large number of bonds to raise cash, causing havoc in the fixed income market.

“There has been a gradual structural shift with the asset management industry requiring more liquidity, and that may outstrip the ability of the banks to provide it in very stressed situations,” Mr. Macklem said.

This happened last March when investors panicked and demanded cash. Funds were hit by redemption requests and margin calls and were forced to sell their fixed-income assets. At the same time, banks, which typically act as market makers willing to buy and sell bonds, withdrew from the market to focus on lending to hard-hit businesses. Bond markets nearly seized up, even for the safest assets such as Government of Canada bonds.

The central bank stepped in with a range of market liquidity measures, and by mid-April bond markets had largely returned to normal. But the experience last March showed how vulnerable fixed-income markets have become in moments of crisis.

The bank said it is also monitoring financial risks related to climate change and cyberattacks, and it is eyeing the rapid development of the cryptocurrency market.

“Despite their growing popularity, these [cryptocurrency] markets are not of systemic importance in Canada, neither as an asset class nor as a payment instrument. But this could change if a large technology firm – a so-called Big Tech [company] – with a sizable user base decided to issue a cryptocurrency that became widely accepted as a means of payment,” the bank said.

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