How sensitive are CAD households to higher interest rates?

Benjamin Tal: But there is another aspect here that we are learning more and more from recent communications from the Bank of Canada. And that’s the housing market. They are terrified that the housing market will take off the minute they cut interest rates or even tweet about the possibility of cutting interest rates. That’s exactly what happened in early 2023 when the bank said that they are going to pause. Remember what happened to that spring?

Bipan Rai: Welcome everyone to another edition of the FX Factor podcast. Heading into this year, the question on a lot of minds was to what extent Canadians were vulnerable to rising interest rates. After all, Canadians are known for several things, including maple syrup, hockey, being polite, and of course, being incredibly levered. And Canada generally does show up in assessments when international statistic agencies look at household vulnerabilities to higher interest rates. But when do the impacts of higher interest rates on domestic credit morph from being a macro concern to something more nefarious related to credit quality. For that, we’ve brought back one of our favorite guests, Benjamin Tal from our Economics department. Ben, welcome back.

Benjamin Tal: A pleasure, how are you?

Bipan Rai: I’m well, I’m well. So, let’s get started. And the Bank of Canada right now is running the tightest monetary policy it’s run in a generation. And while things appear manageable so far, we are seeing some pain in a few areas related to household credit. Can you walk us through some of the trends you’re seeing in consumer credit and mortgage lending?

Benjamin Tal: Yes, for many, many years it was a scenario. It was a stress test. Higher interest rates, what will be the impact? It was a theoretical exercise. Now, over the course of breakfast, we have seen interest rates rising by 475 basis points. So it’s no longer a stress test, it’s a reality with major implications. So let’s start and look at what’s happening. First of all, let’s look at credit growth. It’s basically zero adjusted for inflation. The last time it was zero was 1982. Even 1991, a major recession with a major housing market crash was above zero. So this is the weakest since the 1980s. Now, if you look at the slowing credit, its demand and supply, namely supply limits are going down notably, no question about it, but also utilization rate of credit is down. So basically, borrowers are looking at those rates and say, thanks, but not thanks, I don’t need this credit. So utilization’s went down. So credit is down for two reasons, supply and demand. And then the question is, okay, what’s happening with insolvencies? Now we have to remember, they are rising by 20% a year. That sounds like a lot, but it’s starting from an extremely low base. In fact, per capita, insolvencies are not rising as quickly as previous recessions, including the 95 slowdown. So we have a situation in which so far so good. Now, when we say insolvencies, we have to remember that insolvencies is a summation of two things. It’s a bank abscise and proposals. Bank abscises are down 80 percent, 80 percent, eight zero of now insolvencies are proposals. Basically, the bank negotiates with the borrower and basically saying, you know what, don’t go under. Let’s fix something here. And that’s actually a win-win situation for the borrower and the lender. So there is this element of negotiation now that we haven’t seen in previous recessions. More examples is if you look at the delinquency rate that moved from 30 to 60 days, this category is rising. But now what’s interesting is that if you look at the delinquencies that are moving from 60 days to 90 days, it’s actually down. Again, bankers are saying, listen, let’s talk. Let’s have a coffee, let’s talk, let’s see what makes sense, what doesn’t. And actually you reduce losses by doing so. Another example, remember the trigger rate situation in which most of your payments are going, or all your payments going towards interest on your mortgage? It’s down from about 20% of outstanding to 15. Again, banks are doing something right in terms of negotiating with borrowers, and that’s actually a good trajectory that we’re seeing in the market. However, delinquencies are starting to rise and we have to look at the situation exactly what you said, to what extent it’s a credit quality story as opposed to just a macro story. And it seems that it’s starting to be, if you look at the right numbers. First of all, let’s start with the most trivial and that’s the mortgage market. We know that 50% of mortgages already repriced, 50%, that’s the good news. The bad news, 50% of mortgagees will have to reprice over the next three years. The average increase is going to be 15 to 17% in terms of payments. That’s the average over the next three or four years. However, this average, and that’s extremely important to understand, includes 35% of borrowers that will be paying less. Because last year, they renewed for one year, and interest rates will be lower. So they actually will be paying less. So this 15% includes actually 35%, one third of borrowers that will see their payments going down, which means that for the rest, the payment will be much more significant. About 15% of borrowers will see more than 35% increase in their payments. That’s significant, and that’s something that is risky in my opinion, and that’s why we have to look deep into signs of vulnerabilities in terms of delinquencies. I start with the mortgage market, and I don’t look at delinquency rates. I don’t care about them. I care about leading indicators. So I look at the 30-day rate of subprimers, the margin of the margin. And those rates are starting to go up. They’re already higher than 2019 level. To me, it means that the delinquency rates in the mortgage portfolio will continue to rise, and that’s not a big surprise. It’s again, rising from a very low base, but already higher than 2019 level, which is basically a level that was in the past reasonably healthy nights above that level. Now, what about other indicators? For example, what happens to the non-mortgage portfolio of mortgage holders, namely credit cards and lines of credit of mortgage holders? Because if you have mortgage holders and you have an issue, you will not default on your mortgage first. You will default on your credit card or lines of credit. So we have to look at that. You know, non-mortgage credit held by mortgage holders. And there we can see again, if you look at the subprime space, the 30 day, the 90 day, starting to rise again, higher than the 2019 level, another sign of vulnerability. And then, of course, you want to look at the renters that are 30% of the population. And there, again, line of credit going up very, very significantly, especially the subprime space. So the point that I’m making here is that there are some signs of stress in the portfolio, and it’s going to get worse in time, especially with the housing market getting slower. Remember, all those trajectories are in an environment in which unemployment rate is extremely low. The minute it goes up and it’s starting to go up, as we all know, that will continue to grow. So the bottom line, this is not a major credit story. It’s a major credit quality story. It’s less of a micro story in more than a credit quality story in the sense that the delinquencies will be rising. However, if you look at the rate at which they are starting to rise and our expectations for where the unemployment rate will be going, I think they will stabilize at a relatively healthy level and the most significant impact will be on the consumer. That’s the bottom line of this piece.

Bipan Rai: Okay, so I mean that’s a fairly comprehensive answer, but let’s back up a little bit to some of the things that you mentioned earlier. Now utilization rates for consumer credit are falling, and the fact that we’ve seen year-over-year growth in credit go basically flat or zero for the first time since 1982. I find both of those very, very fascinating when especially, you know, of course we’ve seen the economy kind of stall out a little bit here, particularly over the course of the last three quarters. But you know, you’re still in an environment where the unemployment rate is low. What accounts for that drop in demand for credit at this point? Is it the fact that you are seeing these rises in insolvencies?

Benjamin Tal: Well, I think a few things are happening. First of all, if you are a mortgage holder and you know that six months from now, your payments will be rising by 30%. What are you going to do? You’re going to start increasing your savings and that’s exactly what we are seeing reflecting a weak economy. I think higher interest rates are clearly a factor where, you know, qualifying to mortgages basically is almost impossible at this point. So clearly the demand is not there because of that. And clearly the supply is not there because banks are not taking any risks. So all those factors lead to a significant softening in credit growth as we have seen over the past few months.

Bipan Rai: Okay, and we got to bring in mortgages into this discussion. I know you touched on mortgages earlier, but I mean more than one trillion worth of mortgages are set to renew in the coming years. And you wrote a piece a couple of weeks ago about what we’re talking about today and you mentioned that an average interest payment shock of about 15 percent, but that does mask some things that actually could skew that number a little bit higher. Can you just briefly touch on or at least explain what that means for the audience here?

Benjamin Tal: Yes, because the 15% is a nice number and people say only 15%? I say no, because 35% of mortgage holders already renewed over the past year or so for one year. Which means that when they renew again, part of this 50% that will renew, their rates will be actually lower because interest rates are going down, the five-year rate is down. So clearly, one-third of borrowers will see their mortgage interest payments going down, which means that the 15% is masking that number, it’s including this number. So if you remove that number, the average is much, much higher. And as I said, there is about 25% or 20% of borrowers that will see their mortgage payments rising, mortgage interest payments rising by 25 to 30%. So this is a significant increase. So I think that the average is masking a lot of interesting information there.

Bipan Rai: Yeah, and circling back on homeowners and I guess the degree to which, at least the types of credit and whether or not we’re seeing delinquencies rise there, a key segment is renters and I know you’ve touched on this in the past as well. This segment accounts for the overwhelming share of delinquencies. What are the trends we’re seeing amongst renters in Canada?

Benjamin Tal: First of all, the risk profile of renters is extremely higher. If you look at the share of delinquencies compared to the share of outstanding, it is much higher. And rightly so because they are younger, their labor market attachment is not as strong. All those factors suggest that they are more risky and that’s exactly what we see in the risk profile, in the credit score, in all those forces. And yes, their delinquency rates are starting to rise faster than homeowners, again, reflecting impact of higher interest rates and the employment number that is more volatile for them at this tricky part of the cycle because many of them are low paid individuals. So all those forces suggest that the risk profile here is rising and we are starting to see it already in the delinquency rate on the lines of credit. We haven’t seen it yet in the credit card story, but that’s coming. So clearly the lines of credit rising very fast among renters that represent a higher risk profile in the market.

Bipan Rai: Okay, so let’s touch on something else that you’ve referenced in the past as well. That’s the concept of sudden insolvencies. I mean, if we look at insolvency rate versus the 90-day delinquency rate, there’s an interesting relationship that’s developing there. Can you speak a little bit to that and let our audience know what that is?

Benjamin Tal: Yes, that’s very interesting. Usually we have a situation in which you are delinquent for 30 days, you go to 60 days, 90 days and then you start talking to the bank. This time around, we see a situation in which people are skipping this kind of environment and go to insolvencies immediately. And maybe one of the reasons is they know that they can actually negotiate this insolvency with the bank and get a proposal. So they are skipping the trajectory of 30, 90 days and go directly to insolvencies. And these numbers has been rising. So what I’m saying here is that when you look at forecasting insolvencies in the market, you cannot just look at the delinquency channel. We have to look actually at also sudden delinquencies, sudden bankruptcies, and that’s exactly what’s happening.

Bipan Rai: Okay, so I mean at the margin we’re seeing vulnerability to rates rise. But you said this earlier, I’m just going to repeat the question again. Should we be worried about broader credit risk here in Canada, even if the unemployment rate does rise as we expect in the coming months and quarters?

Benjamin Tal: Yeah, I think the delinquency rates will be rising, insolvencies will be rising from a very low rate, but I think that the big story here is a macro story, the impact of higher interest rates on consumption that will slow down the economy. We are already in a per capita recession. The consumer is a shadow of its former self. So I think in this environment, it’s more a macro story than a credit quality story, although delinquencies will be rising. And that’s why banks have been putting so much money aside.

Bipan Rai: So how does the Bank of Canada interpret all of this as it looks forward and it crafts its policy for the period ahead?

Benjamin Tal: That’s a very good question. I think that the consumer is clearly a very important part. And that’s one of the reasons why I believe that the Bank of Canada is already overshooting. I was very vocal about the increase of 50 basis points during the summer. I think it was unnecessary. And now I think it’s very clear that it was unnecessary. We also have to realize that those increases in the summer were very powerful because before that, when you raise interest rates, there was still excess savings that protected the consumer. Today, the consumer is basically naked, totally exposed to higher interest rates because of the fact that the excess savings story is basically zero. So the increase in the summer, I think was a very significant one with much more power than previous hikes. And that’s something that really helped the economy. And I think that basically overshooting is happening, I believe in 50 basis points. I think that the Bank of Canada at this point should clearly consider to start

cutting interest rates very quickly. I think they should cut now, but of course they will not do that. Our call is that the Bank of Canada will be cutting in June. We’ll start cutting in June, 100 basis points in the second half of this year.

Bipan Rai: Okay, so I mean, sticking with the bank, there’s been a lot of chatter, especially with respect to core inflation gauge and which one amongst many in the inflationary buffet that it should really be paying attention to. You know, there’s a nice note published by your team about a month ago, really extolling the merits of the old CPIX gauge over trim and median. Where do you stand on the core inflation debate and which gauge should the Bank of Canada really be looking at?

Benjamin Tal: Yeah, my point is a bit different. My point is that remember, you know, if you go back to the 1990s, the focus was on CPI and core CPI, which is the CPI minus energy and food. And then in the 2000s, they added CPI-X, fine. So you had three measures to focus on. And lately we got trim, common, medium, and service excluding shelter. So we have five CPI measures to focus on. Back then again in the past, the focus was year over year. Now it’s a year over year, year over year, three months moving average. And of course, nobody cares about what happened a year ago. So now we’re focusing on month over month, three months moving average annualized, six months moving average annualized. So all of a sudden, we have a metrics of five by six of inflation numbers that we have to focus on. That’s 30 inflation numbers every time Stats Canada releases the inflation number. 30 numbers to look at. That’s an inflationary buffet. And we have a situation in which there is enough there for anybody. So if the Bank of Canada wants to be hawkish, they focus on the numbers that are threes and fours. If they want to be bearish, they focus on the numbers that are zero and one. Therefore, what I’m telling you here, and that’s extremely important, the narrative derives the data. Not the data derives the narrative. I have in front of me on my screen, those 30 numbers. Eight of them are above 3% or 2.5%. And where is the most damage? On trim and medium. All the rest, including CPI-X by the way, are way below target or around target. So we have a situation in which the narrative determines the data. And that’s why I’m really not looking at the numbers anymore. I’m listening to the Bank of Canada because they can choose whatever number they want at this point. And I think that if you ask me what will happen over the next few months, the focus on trim and medium, which is still around 3% on the year over year, will go down and down and down. And the Bank of Canada will go back to the old fashioned CPI-X, which is now behaving to justify a June cut.

Bipan Rai: I’m very much aligned with you, Benny. I think they should be cutting already. But I mean, why is there such a heavy reliance on, you know, somewhat flawed gauges with respect to trim and median?

Benjamin Tal: I really think that they are taking the time to overshoot and you can overshoot in two ways. One is you raise interest rates way too high, which they did, also keep them high for longer than needed. And that’s exactly what they’re doing. Why? Because they want to make sure that inflation is dead. But there is another aspect here that we are learning more and more from recent communications from the Bank of Canada. And that’s the housing market. They are terrified that the housing market will take off the minute they cut interest rates or even tweet about the possibility of cutting interest rates. That’s exactly what happened in early 2023 when the bank said that they are going to pause. Remember what happened to that spring? The market was on fire. That’s the fear. And I totally sympathetic to this fear, because if you look at the housing market now, it’s waking up. The condo market, all of a sudden, the resale market is moving back to the old days of beating wars, especially at the under one million territory. So I think their fear, their nightmare is a situation in which they start cutting interest rates, and this crazy housing market will take off, and that will sabotage everything. That’s more or less where we are now.

Bipan Rai: You mentioned our call for the Bank of Canada earlier, namely that we expect the Bank of Canada to start easing in June, and then that will be followed by an additional four cuts on balance for the rest of this year. Can you speak a little bit about how that impacts your outlook for the housing market here in Canada?

Benjamin Tal: Yeah, I think the housing market will take off in the spring. I don’t think it will be a very strong market. I think that it will be a tale of a few markets. Let’s start with the condo market. The condo market, the less than one million will do extremely well in the resale market, not in the new construction market. So we have to distinguish in the condo market between a resale market that is starting to do well and the pre-sale market that is extremely expensive and the gap between pre-sale, new construction.and the recent market is at a record high. So people are not buying pre-sale. In fact, it’s going down dramatically. That’s something that worries me a lot because it means that supply two years from now will not be available because nobody’s building. But the recent market under one or maybe even $1.5 million will do extremely well in the condo space. Anything between two and $5 million in the market is doing basically okay, but relatively weak compared to lower prices. And anything more than $5 million is doing extremely well. A lot of demand, there are not enough supply. Depends where you are in the market in this environment to basically come up with a narrative. But overall, I think the spring will be fine and the fall will be on fire, I believe. And that’s one thing I think that will limit the ability of the Bank of Canada to cut interest rates. And that’s the risk of higher for longer.

Bipan Rai: So that was going to be my next question. What is a big risk to our profile for the Bank of Canada? And it sounds like it’s really the housing market in your view then, is that correct?

Benjamin Tal: Absolutely, and I think that if there is a risk to our forecast is that interest rates will be falling by less than our forecast. We see the overnight rate reaching 275 by let’s say the end of 2025. The risk it will be higher than that reflecting the craziness of the housing market and the mismatch in supply and demand there.

Bipan Rai: Well, you heard it from Ben. That’s our Bank of Canada forecast again. For those of you that missed it earlier, we see the bank beginning to get ease rates as soon as June. How does that impact our DollarCAD outlook? Well, we’ve got DollarCAD remaining within the broader $134 to $136 range. There is a chance we could probe a little bit above the $136 level, but we suspect that a lot of dollar sales will get active above that level. And again, if we’re right on a call that the bank is likely to cut rates in June. And then it makes sense potentially to start looking to get active above the 136 level and potentially sooner as well, not least as we expect that discount at which the 30 month forward is trading relative to spot to widen if we’re right. So again, think about that. Think about everything you’ve heard today from Benny, especially when it comes to the outlook for the Canadian credit scene and of course what we’re anticipating for the Bank of Canada. But you know what? For now, we’ll cut it off there. And Ben, thanks again for joining us and I’d love to have you back sometime soon.

Benjamin Tal: Thank you, a pleasure.

Bipan Rai: Alright, until next time everyone.

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