Actions have consequences

For much of the past year the Bank of Canada has been aggressively raising interest rates as it attempts to get inflation back to the 2 percent target. Its overnight rate target has risen from 0.5 percent to 4.5 percent, pushing up borrowing rates all across the yield curve. It is no surprise, then, that in its latest Financial System Review (FSR), published this morning, the Bank admits that it is "more concerned than it was last year about the ability of households to service their debt". 

Canada's high household debt has been on the radar for several years, not only at the Bank of Canada but also at international agencies like the IMF and OECD.  Low interest rates during the COVID era kept the lid on the problem, but it was always likely that stresses would begin to emerge once rates started moving back to more "normal" levels. That process is now underway, and the resulting problems are likely to continue to emerge over a period of several years.

In the Bank's words,  "While most households are proving resilient to increases in debt-servicing costs, early signs of financial stress are emerging". Thus far only about one-third of households have seen their mortgage payments increase, comprising those on floating rate mortgages and those unfortunate enough to have a rate reset in the past year. Since most Canadian "fixed rate" mortgages actually have a reset every five years or less, the percentage of households facing higher monthly payments will increase steadily right through 2026.  This fact alone makes Governor Macklem's warning that rate are unlikely to come down any time soon highly significant for the household sector.

In the meantime, amortization periods are already starting to stretch out. Fully 46 percent of new mortgages in 2022 had an amortization period of over 25 years, up from 34 percent in 2019.  The share of households falling behind on debt servicing is actually below its historic level, but has been rising since mid-2022. Moreover, it looks as if many households are only coping by running up credit card debt. Outstanding credit card balances are higher than they were pre-pandemic, with particular growth noted in credit card balances of newer mortgage borrowers. 

For now the Bank seems to think the situation is manageable, but it naturally worries about what could go wrong: "A severe recession with significant unemployment and further reductions in house prices could cause substantial financial stress for some households. Lower home equity could limit refinancing options on mortgages, leading to an increase in defaults. Credit losses to lenders would also rise if the liquidation value of a home in default is less than the value of the outstanding mortgage".

Aside from household debt, the FSR is reasonably upbeat about the stability of the system.  The Bank of Canada has some concerns over the possible impact of a severe recession on the banking system, but it points to "sound risk management and supervisory practices in Canada".  There are also sections of the report dealing stability issues with non-bank financial intermediaries, non-financial businesses, cryptocurrencies ("not currently significant"),  cybersecurity ("concerned")  and climate change ("significant"). It's a long list, but there is no doubt that it is the financial health of the household sector that haunts Governor Macklem's sleep at nights.