Shortly after yesterday’s rate hike by the Bank of Canada, its first since 2010, we warned that as rates in Canada begin to rise, the local economy which has seen a striking decline in hourly earnings in the past year, which remains greatly reliant on a vibrant construction sector, and where households are the most levered on record, if there is anything that can burst the local housing bubble, it is tighter monetary conditions. And a bubble it is, as the chart below clearly demonstrates… one just waiting for the pin, which as we suggested yesterday in “”Canada Is In Serious Trouble” Again, And This Time It’s For Real“, may have finally been provided thanks to the Bank of Canada itself.
Now, one day after our warning, the IMF has doubled down and on Thursday issued its latest consultation report, in which it said that while Canada’s economy has regained some momentum, it warned that business investment remains weak, non-energy exports have underperformed, housing imbalances have increased and uncertainty surrounding trade negotiations with the United States could hurt the recovery.
The report – which concerningly was written even before the BOC hiked rates by 0.25% – also said the Bank of Canada’s current monetary policy stance is appropriate, and it cautioned against tightening.
“While the output gap has started to close, monetary policy should stay accommodative until signs of durable growth and higher inflation emerge,” the IMF said, adding that rate hikes should be “approached cautiously”.
Directors noted that Canada’s financial sector is well capitalized and
has strong profitability, but that there are rising vulnerabilities in
the housing sector… Directors agreed that monetary policy should stay
accommodative and be gradually tightened as signs of durable growth and
inflation pressures emerge. They recognized that monetary easing could
complement fiscal stimulus, and may need to be considered along with
unconventional measures if economic activity contracts significantly,
although there is a risk that it could exacerbate housing imbalances.
While one can accuse the IMF of being traditionally dovish: recall Christine Lagarde – who famously said the IMF would be out of business if there were no world crises – has been screaming at central banks for hiking rates (in retrospect she will be proven right, just not yet), in this case she may be right: the recent sudden surge in Canadian interest rates especially on the long end will have a severe impact on loan demand, not to mention mortgage rates and, of course, housing demand.
Furthermore, in a statement following its annual policy review with Canada, the IMF
cautioned that “risks to Canada’s outlook are significant” particularly
– drumroll – “the danger of a sharp correction in the housing market, a further
decline in oil prices, or U.S. protectionism.”
Risks to the outlook are significant. On the upside, stronger-than-expected growth in the U.S. could boost export and investment in the near term. On the downside, risks stem from several potential factors—including the risk of a sharp correction in the housing market, high uncertainty surrounding U.S. policies, or a further decline in oil prices—that can be mutually reinforcing. Policy choices will therefore be crucial in shaping the outlook and reducing risks.
The monetary fund also said that financial stability risks could emerge if the housing correction is accompanied by a recession, but there was good news: the IMF noted that recent stress tests have shown Canadian banks could withstand a “significant loss” on their uninsured residential mortgage portfolio, in part because of high capital position.
Well, we are about to find out.
Meanwhile, house prices in Toronto and Vancouver have more than doubled since 2009 and the boom has fueled record household debt, a vulnerability that has also been noted by the Bank of Canada. As Reuters adds, some economists believe the rate hike this week was at least partly aimed at reducing financial system imbalances, which is admirable… the only problem is that the first casualty of a correction in imbalances will be the blue line in the chart at the top.
“The main risk on the domestic side is a sharp correction in the housing market that impairs bank balance sheets, triggers negative feedback loops in the economy, and increases contingent claims on the government,” the IMF warned, sounding the loudest alarm yet on Canada’s economy even if it was reiterating previous warnings about Canada’s long housing boom.
There was another danger: Trump. The Fund also warned U.S. trade protectionism could hurt Canada’s economy, and laid out a scenario for an increase in tariffs that could come with the renegotiation of the North American Free Trade Agreement. The IMF was also kind enough to quantify just how little it would take to send the local economy into a tailspin: the IMF said if the United States raises the average tariff on imports from Canada by 2.1 percentage points and there is no retaliation from Canada, there would be a short-term negative impact on real GDP of about 0.4%. Naturally, if tariff increases were higher, an outright recession was virtually guaranteed.
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