Canadian Household Update: Headwinds to Persist Through 2023

2022 brought a difficult adjustment for many Canadian households as the Bank of Canada's hiking cycle heralded a shift from years of low interest rates. While most households with a fixed rate mortgage have yet to renew, those renewing a fixed-rate loan over 2023 and 2024 will do so at a significant premium to their previous contracts. This will continue to push the average mortgage rate for outstanding loans higher even after the Bank stops tightening, which will result in larger debt payments and a rising debt service ratio into 2024.

Fixed rate loans account for roughly two thirds of mortgage debt in Canada, but variable rate mortgage issuance had surged in the months before the first hikes. Fixed-rate mortgages became more expensive than variable rate loans once markets began to price in Bank of Canada hikes, and with stress tests making it more difficult to qualify this pushed borrowers towards variable rates. Variable rate loans accounted for >50% of total mortgage issuance from July 2021 to May 2022, which resulted in the share of variables outstanding rising from 23% to 32% over that period.

As the Bank began to lift rates in March, those with variable rate mortgages saw interest payments rise in lockstep with the Bank's overnight rate. The early stages of the tightening cycle had a mild impact – debt service ratios were well below the 2019 peak entering 2022, and household balance sheets were buffered with ~$360bn in savings accrued over 2020 and 2021. However, 5y fixed-rate mortgage renewals carried a 100bps premium by June 2022 and by October households were renewing 5y fixed rate loans for 200bps above their previous contract rates.

The coming year will continue the painful adjustment for many households, even as the Bank of Canada signals the likely endpoint of its tightening cycle. We are well past the peak for headline inflation, but persistent core inflation and an exceptionally tight labour market are expected to keep the Bank from cutting rates until 2024. In the interim, we should see ~$275bn in fixed rate loans renew over the course of 2023.

We expect mortgage rates will remain historically elevated through the end of the year. Canadian lenders have yet to incorporate the recent decline in Government of Canada yields into their pricing for 5y mortgage rates, and we think it is unlikely that fixed mortgage rates will see a material decline until the Bank of Canada is much closer to easing. As a result, debt service ratios should continue grinding higher over the course of the year as homeowners renew fixed rate loans at a large premium to their previous contract.

Overall, we expect those renewing fixed rate mortgages will see their fixed mortgage rate (and total interest payments) rise by ~35% from last year, which translates to another $3.5bn for interest in 2023. This pales in comparison to the $13bn in additional interest for those on variable rate mortgages, although these borrowers have already seen the adjustment take place over the last twelve months. However, we would note that Bank of Canada (BoC) mortgage lending data only captures ~75% of the residential mortgages on household balance sheets, so we would treat these as lower-bound estimates.

The household debt service ratio (DSR) rose by just 0.14% in 2022Q2 in the first stage of the BoC's tightening cycle, but debt servicing costs began to rise more sharply in the second half of 2022. Total debt payments jumped 5.6% q/q (non-annualized) in Q3 as interest payments surged by 16.2%, pushing the DSR 0.5pp higher to 13.97%. We expect the DSR to rise another 0.5-0.6pp in Q4 and test the record highs (15.0%) by 2023Q1, before pushing towards 16.0% by the end of 2023.

Fixed rate mortgage renewals will continue to put upward pressure on payments through 2024, even with some moderation in actual mortgage rates. 2-5yr mortgages up for renewal in 2024 carry an average fixed rate of 2.95%, which is well below where we expect households to renew next year. However, we look for the DSR to peak in 2024Q1 as variable rate mortgages provide some relief over the second half of 2024.

The material excess savings accrued through the pandemic will help mitigate the impact of rising mortgage payments for some households. Since 2019Q4, households have set aside nearly $425bn in total savings, exceeding the total from 2009-2019 period. Household savings rates have not yet normalized to pre-pandemic levels – excluding the COVID period, the 5.7% savings rate in 2022Q3 was still the highest since 2013Q1. Bank deposits as a share of nominal GDP remain 4.3% above pre-pandemic levels, which translates to another $120bn in savings that are readily available. Deteriorating economic conditions and weak consumer sentiment may discourage households from deploying these savings over the first half of 2023, but if savings are not tapped, they can still provide fuel for the recovery into 2024.

Another mitigating factor to the impact of mortgage renewals is that 2017/18 was a relatively quiet period for the Canadian housing market. Toronto home sales saw a sharp pullback after the foreign buyer tax was introduced in April 2017, and nationwide existing home sales took another hit after stress tests were implemented at the start of 2018. As a result, there are fewer 5yr fixed rate mortgages up for renewal in 2023 than the last two years.

The Bank of Canada has cited household leverage as a key factor behind its shift to a conditional pause in January, which should keep DSRs in focus as the Bank assesses the impact of its tightening cycle. We look for the Bank of Canada to remain on hold at 4.50% through 2023, though markets do see a higher probability of another hike now after a stringer of stronger Canada and US data. With pressure on households expected to grow more intense over 2023 as past policy tightening works its way through the economy, this could make for a challenging backdrop on possible further interest rate hikes, should inflation prove more persistent than anticipated.