It has been a challenging year for households, with inflation rising to levels not seen in decades and interest rates spiking at an unprecedented pace. The swooning loonie is making imported goods more expensive. Investors, meanwhile, have been faced with steep declines in both stock and bond markets.
A report Wednesday from TD Economics suggests this pain felt by households may get worse before it gets better. The bank expects to see contraction in Canadian consumer spending, a rise in unemployment and little to no economic growth. While TD expects home prices may soon stabilize, it believes the housing market will face a slow recovery with borrowers facing even higher mortgage rates in the near term. The Bank of Canada may be nearing the end of its tightening in monetary conditions, but TD still expects 75 basis points more in hikes to its overnight lending rate. That will ultimately bring the key interest rate to a peak of 4.5 per cent, representing a relatively wide interest rate differential with the U.S. that will keep the Canadian dollar under pressure.
Here are some highlights of the TD report.
Rising household costs
TD notes that housing costs are exponentially higher compared to a year ago, taking a large bite out of consumers’ disposable income. “Mortgage payments on the average home purchased five years ago could increase by $350 per month when renewed in the third quarter of this year, if the amortization length was left unchanged. Canadians’ exposure to variable rate mortgages is also significant. Variable rate mortgages surged in popularity during the pandemic and now account for 34 per cent of the overall stock of mortgage credit, higher than the previous peak of 25 per cent in 2018. As Canadians dedicate more to housing, hard choices will be made with discretionary spending, like dining out and travel likely to take a hit. We have downgraded our consumer spending forecast to reflect a sustained period of sub-1 per cent growth in consumption in 2023 and 2024.” As a result, TD is forecasting roughly no growth in Canadian GDP in 2023 with the unemployment rate peaking at 6.5 per cent, up from 5.2 per cent reported in October. “We agree that the Canadian consumer is about to get squeezed.”
Soaring interest rates have cooled housing activity dramatically with affordability collapsing for many home buyers. In October, home sales declined 36 per cent year-over-year. Fears about a recession, inflation remaining high and rising unemployment are making home buyers nervous. However, TD economists believe that most of the damage in the housing market has already been done. TD Economics forecasts the average home price in the country will fall just over 20 per cent from the peak reached earlier this year to the trough. If TD is right, this suggests that housing prices are nearing a bottom. In October, data from the Canadian Real Estate Association (CREA) showed that the average home price in Canada declined to $644,643, which is down 21 per cent from the record $816,720 set in Feb.
While TD expects home prices may soon stabilize, its economists say a recovery will take time. “Our baseline forecast also expects resale supply to remain sluggish over the next few quarters, as potential sellers remain hesitant to list their homes amid a weak backdrop. After which, an orderly increase in supply is expected to take place, as markets find a bottom next year, and demand and prices begin to recover.” The report added, “Once Canada’s housing market adjusts to this historic hike cycle, housing supply will face tremendous pressure to keep up with the federal government’s new immigration targets, which envision 465k, 485k and 500k newcomers entering the country in 2023, 2024 and 2025, respectively. If achieved, each year would mark a record high for immigration and means that demand for rental units will stay strong. Eventually, these cohorts will transition towards demanding ownership housing.”
Bank of Canada’s pivot
This is perhaps one of the most anticipated recessions in recent memory and given that central banks are acutely aware of the heightened risks, we may be able to avert a hard landing – at least that’s the hope. Key questions that will determine the health of the economy include: When will the Bank of Canada stop aggressively raising rates? What will the terminal rate be? And when will interest rates start to come down?
TD suggests that the Bank of Canada has already pivoted. “Despite rhetoric by the Bank of Canada that now was not the time to ease up on rate hikes, the Bank of Canada scaled down its hiking path with a surprise 50 basis point increase in October. If you were wondering what changed, you weren’t alone. Market expectations were fully priced for a 75 basis point increase and that the central bank would closely follow the Federal Reserve through the first half of 2023. Now with the BoC’s pivot, markets have the Canadian policy rate peaking half a percent below the fed funds rate.”
TD expects the Bank of Canada will bring it’s overnight lending rate to 4.5 per cent, up from the current 3.75 per cent, with the U.S. federal funds rate topping out at 5 per cent. “We have consistently been of the view that the Fed will overpromise and under deliver on the peak level for the fed funds rate. This is required tactically to anchor inflation expectations and prevent a premature easing in financial market conditions through relief rallies. Come December’s FOMC meeting, we are expecting a 50 basis point hike, followed by 25 basis point increments in the early part of 2023 as needed. This will allow the Fed time to pause and watch the impact of its past policy actions on incoming economic data.”
The decoupling in the pace of rate hikes between the Bank of Canada and U.S. Federal Reserve has put downward pressure on the Canadian dollar. In October, the loonie fell to a two year low in the low 70 cent level before recovering to its current mid 70′s level.
“The depreciation runs counter to the Bank of Canada’s ability to bring down inflation. As a small open economy, Canada has always been susceptible to currency fluctuations and the related transmission to prices for a wide range of heavily imported products, ranging from living room sofas to avocados. In this cycle, food costs in the CPI basket have been particularly problematic for the BoC. While overall CPI has grown by 6.9 per cent year-on-year (y/y) in October, food prices shot up well above that at 10 per cent. Most of this increase is from a necessity – food purchased from grocery stores (up 11 per cent y/y), instead of food purchased from restaurants (up only 7.7 per cent). Supply chains and energy costs were already at play here, and now the lower Canadian dollar is providing an additional layer of price pressure. For the BoC, this is somewhat of a double-edged sword. The BoC is more constrained than the Fed in raising interest rates due to the real risk that it triggers an unorderly deleveraging cycle. But at the same time, a widening interest rate differential between the two countries weakens the Canadian dollar and pressures import prices.”
Given the balancing act required by the Bank of Canada, TD Economics forecasts the loonie will remain under pressure, hovering around the low 70 cent level in early 2023.
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