Title: Taking away the punch bowl

Sub-title: Borrowing costs have been low for some time now. But that may change soon.

 

Canada’s real estate sector entered the New Year with a huge tailwind at its back. Most key indicators of both current and future performance, including GDP growth, jobs and industry statistics are either heading in the right direction or are downright bullish.

 

In a Monetary Policy Report released this week, the Bank of Canada raised its growth projections for the Canadian economy, which it now expects to expand by 2.9 percent this year and by close to 3.5 percent during 2011. “Economic growth is expected to become more solidly entrenched over the projection period as self-sustaining growth in private demand takes hold,” the bank said.

 

As if that was not enough, the Canadian Real Estate Association reported last week that existing homes sales through its multiple listing service hit an all-time high of 27,744 units during December, a full 72 percent higher than the total recorded one year earlier. House prices are doing well too. The average price of homes sold during December came in at $337,410, up 19 percent from the previous year.

 

Construction activity is also starting to pick up. According to the Canada Mortgage Housing Corporation, housing starts reached 174,500 units on a seasonally adjusted basis. That pace remains far lower than the average of the past five years, through it represents a respectable bounce-back from the recession level lows of earlier this year.

 

That said the one big elephant sitting quietly in the corner of the room is the question of what will happen to interest rates, whose current low levels have driven much of the economy’s recent strength.

 

Why interest rates matter

Two days before the release of its Monetary Policy Report, the Bank of Canada announced that it would maintain its overnight rate target at ¼ percent and reiterated its conditional commitment to maintaining it at that level until at least the end of the second quarter.

 

However the Canadian economy’s recent strength has some economists thinking that the central bank may act sooner. “We are wondering whether the bank has paid enough attention to the degree at which Canada’s job market has performed better than America’s,” said Yannick Desnoyers, assistant chief economist at National Bank Financial. Desnoyers, worked at the Bank of Canada for several years before taking on his current gig, and thus has special insight into its inner workings. He believes that the central bank could begin monetary tightening as early as April.

 

Central bankers worry that if an economy picks up too fast, then inflation – and asset bubbles - could begin to form. And while the inflation numbers continue to look well contained, many observers have noted that Canada’s housing market is beginning to look slightly overvalued relative to personal incomes and rents. Furthermore, according to Desnoyers, capacity utilization, particularly in the service sector (which represents 75 percent of the Canadian economy) is not nearly in as bad a position as experts believe. That means companies could start boosting their prices sooner than expected.  

 

Because the Bank of Canada’s traditional response to inflation threats has been to raise its policy rate, its role has been likened to taking away the punch bowl just as the party is getting started. A central bank rate hike has a significant influence on short-term market interests, notably short-term mortgage rates. That’s important because interest payments represent by far the single largest expense for many homebuyers.

 

So what will happen?

However not everybody agrees with Desnoyers that interest rates will come back up that soon. “We pretty much agree with the Bank of Canada’s reasoning and time table, and expect that rates will increase in the second half of the year,” said Adrienne Warren, an analyst at Scotiabank Group. “As a result, it would probably be better to buy a new house sooner rather that later.”

 

Warren is not alone. “We still project that 2010’s growth rate will fall short of those recorded during the early stages of previous recoveries, which will result in the bank holding off until the summer,” wrote Dawn Desjardins, assistant chief economist at RBC Economics, in a recent note to clients. Desjardins believes that the central will ultimately increase its policy rate by a full one percentage point during the second half of the year.

 

That may not sound like much, but if the move affects mortgage rates by a similar amount, it would boost monthly mortgage payments on $200,000 30-year mortgage by $125 or $1,500 over the course of one year. And if you extend that mortgage rate increase out over the life of the mortgage, those who buy their first homes later in the year, could pay up to $45,000 more in interest payments.

 

That buys a lot of punch bowls.

 

 

Peter@peterdiekmeyer.com

 

 

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