Interest Rates: Why the Sky Isn’t Falling

This week’s post also appears in the September issue of REM magazine.

What a roller coaster ride the last two years have been. In the spring of 2009, Canadian house prices fell across the board and transactions slowed as fears of a global economic downturn spread. But then, as if only pausing for breath, Canada’s real estate market revved up once again and the spring dip looked like nothing more than a good buying opportunity. So why is everyone so nervous? When I talk to realtors, fears of rising interest rates are among the first concerns raised. There is a widespread assumption that rates can only go up, and a related belief that higher rates will hammer the real estate market. In fact, I don’t think either fear is warranted. Here’s why:

Short-term (Variable) Rates Aren’t Going Anywhere Fast Because…

• The central bank’s primary reason for raising rates is to control inflation. Our inflation rate (as measured by the consumer price index) was at 1% as of July 23, 2010, well below the central bank’s upper limit of 2%.
• The effects of higher rates are felt only over time, so raising short-term interest rates gradually allows the central bank time to measure the impact of previous increases before tightening further.
• The real estate market is cooling off. One of the central bank’s main concerns with leaving its overnight rate at emergency low levels was that it would fuel a housing bubble. Today’s more balanced housing market has rendered that concern moot for the time being.
• While the Canadian economic recovery is in full swing, most of the rest of the world is not faring as well. In its recent commentary, our central bank has acknowledged that aggressive interest-rate hikes could stifle our momentum, especially against today’s backdrop of global economic uncertainty.
• The US Fed is not expected to increase its short-term policy rate until 2012 at the earliest. If our central bank keeps raising rates independently of the Fed, our dollar will continue to appreciate and this will slow our economy further. Most experts do not believe that Canadian short-term rates can be sustained at much more than 1% above comparable US rates (and we’re already .75% higher today).

Moderately Higher Rates Won’t Hammer the Real Estate Market Because…

• Contrary to popular belief, there is no strong correlation between rising interest rates and lower house prices. In fact, historical data show that rates and house prices rise together more often than not. Before you say I’m out to lunch, let me elaborate. I readily accept that, all being equal, higher rates hurt affordability and are bad for the housing market.  But all is not equal.  Rising rates generally occur in an improving economy, and the positive economic momentum that accompanies higher rates creates a net effect that has historically proven more positive than negative. (I will elaborate on this point in next week’s post.)
• Job creation has far outpaced any forecasts and is considered one of the key factors in our rapid economic recovery (it’s dropping a little recently but after a very good run). If you’re looking for indicators that foretell the health of our real estate markets, historical data show that job creation (and rising incomes) are far more indicative than the direction of interest rates.
• Canadians can afford higher rates. In a 2009 CAAMP survey based on 40,000 loans, totaling more than $10 billion to purchase houses across the country, the data showed that we borrowed far less than the maximum we could afford. For example, the highest acceptable GDS ratio that lenders are generally comfortable with is 35%, and in the survey, borrowers averaged only 21.8%. Lenders normally set the highest acceptable TDS ratio at 44%, while in the survey borrowers averaged a TDS of 32.3%. Results like this don’t usually correlate with people lining up at the banks to hand in their keys.

While no one can say with certainty what the future will hold, especially with the world in the midst of a massive credit deleveraging cycle, I think the alarmist rhetoric about dramatically higher rates in the near future is overblown (and I’ve been saying this since April when most of the bank’s economists were sounding the alarm bells). Make no mistake, the central bank would like to continue to raise interest rates to provide some additional breathing room for future monetary stimulus, probably from today’s .75% to about 2%. But Mr. Carney and his governors at the central bank won’t do this if it risks smothering the green shoots of our economic recovery. Instead of fast, knee-jerk rate hikes, my money is on gradual rate increases over time, which the data shows Canada’s borrowers can comfortably afford. On balance, even with higher rates, the sky should stay more or less where it belongs – comfortably over our heads.