How Will The Cut In Interest Rate Affect Canadian Economy?

The Bank of Canada cut interest rate in half, from 3% down to 1.25% due to the economic shock caused by the fear of coronavirus as discussed last week by Steve Saretsky. Read as Steve discusses how this change in interest rate will affect our economy and the real estate market.

Cut in Interest Rate & Real Estate Market by Steve Saretsky

Central Banks flinched first, in a coordinated effort to ease financial conditions, interest rates were slashed across many parts of the world, including 50bps from the Bank of Canada. Unfortunately, this did little to ease market uncertainties of further contagion. After all, lower interest rates can’t force people to leave their homes and spend money.

While the spreading of the Coronavirus hasn’t quite hit home for Canadians, there are just a few reported cases so far, it seems unlikely we will be sparred. A managed containment is what we should all be hoping for. And while I am certainly no virus expert, I think it’s worth discussing the economics of it all.

So far, the media attention has been focused on the interest rate cuts and what it could do to our housing market. Yes, the Bank of Canada has just lowered interest rates at a time when the majority of housing markets across Canada are once again showing signs of exuberance. In Greater Toronto, the benchmark price of a home just hit a new record high, and was up 10% year-over-year in February. Further, the Canada 5 year bond yield has plunged, nearing all time lows. In addition, big banks have also cut their prime rate by 50bps. This all translates to even cheaper mortgages for giddy house shoppers heading into the spring market. The natural first conclusion is home prices will rip.

Unfortunately, what we are failing to consider, are the economic ramifications of this black swan event. Just because this has not yet hit home, does not mean we should become complacent. Whether you agree or disagree with the reaction function of markets, the reality is rather grim. Consider this, China, the worlds second largest economy, has essentially shut down over the past few weeks. Italy has just drafted emergency law to ban entry and exit to the whole of Lombardy region – capital Milan- Venice, Padua, Parma & 8 others. Weddings and funerals banned. Cinemas, gyms, pubs, museums all closed. Anyone violating the law can be arrested and fined. Meanwhile, travel and tourism has essentially come to a standstill, with many corporations prohibiting employees from travelling, and at the same time, cancelling major events.

This will have real economic ramifications, and it comes at a time when the global economy has never been more levered. This will undoubtedly result in job losses, just how many, we don’t know. Unfortunately, this puts Canadian households in a difficult position. Remember, Canadian households are the most indebted in the G7, with debt servicing ratios at all time highs, despite record low interest rates. For many years, the Bank of Canada has cautioned the risks of high levels of household debt, noting concerns of an “economic shock” that could eventually tip households over the top. These are the systemic risks that have kept Poloz awake at night.

In fact, his recent comments suggest as much. “The outbreak and its effects could be more persistent,” Poloz said Thursday in a speech. “Consumer and business confidence could be set back for a longer period of time, causing economic growth to slow more persistently. This could include longer-term layoffs, for example. At this point, we simply do not know.”

Further adding, “Indeed, declining consumer confidence would naturally lead to reduced activity in the housing market,” Poloz said. “So in this context, lower interest rates will actually help to stabilize the housing market, rather than contribute to froth.”

Perhaps he is also wrong, we simply do not know. However, I hope this note serves as a means of caution, not reckless exuberance. Media headlines provoking fears of ever rising house prices in the face of falling interest rates are ill-advised, and perhaps dangerous. We should not be ignorant as to the health and economic effects simply because it has not yet hit us. Again, nobody knows for sure what will happen, but critical thinking is certainly warranted. Eventually, like all things, this too shall pass. Stay safe.

Three Things I’m Watching:

1. Greater Toronto Prices hit record high in February, up 10% from last year.

2. These are the last times the Fed & the BoC cut rates by at least 50bps in the same month:

3. Canadian household debt service ratios sit at record highs despite ultra low interest rates.