As interest rates rise, how likely is a recession? Depends on who you ask

Whether or not the economy is on the verge of a recession is a growing question on the minds of consumers and economists. However, it is clear that rising interest rates should cool both the housing market and consumer spending, while other key indicators are starting to send warning signals.

“I would go so far as to say that I don’t think this is potentially looming. Unless there’s a significant change, there’s a recession going on,” said Calum Ross, leveraged wealth management expert and VERICO broker with Mortgage Management Group. He points out that the yield curve – a measure of US Treasury yields that reflects investors’ feelings of risk – has inverted, meaning short-term debt is now more expensive than long-term debt. Historically, an inverted yield curve has been an accurate indicator of an impending recession.

READ: Bank of Canada to follow U.S. Fed’s 0.75% hike in July

“The number of times you see yield curve inversion as a predictor of a recession is very high, but you look at other things to predict it, and one would be rising inflation,” said Ross, adding that Canadians are already feeling the effects of April’s inflation rate of 6.8%, a 31-year high.

“Consumers don’t have a lot of money, so they’re worried about spending because prices have gone up, and they’re going into saving mode,” he says.

As the Bank of Canada embarks on a historically aggressive bullish cycle to bring inflation back to its 2% target range, it will result in fewer eligible mortgage borrowers and less activity in the housing market . A recent Bank of Montreal analysis reveals that today’s mortgage costs are as prohibitive as they were in 1989.

Prices have fallen considerably after the last three rate policy announcements by the Bank of Canada (0.25% hike in March and two half-point hikes in April and June, respectively); May statistics from the Canadian Real Estate Association show that home sales fell 22% year on year and 8.6% from April. Compared to the high recorded in February, the national average price is down more than $100,000.

And given that more large-scale interest hikes are likely in the coming months – the US Federal Reserve implemented a 0.75% hike on June 15, which the BoC will most likely mirror in July – even more variable rate borrowers will see their affordability decline. .

In addition, bond yields, which lock in the cost of borrowing at fixed rates, hit 10-year highs following the announcement of monetary policy tightening and are now higher than they used to be. were before the 2008 financial crisis. This marks the end of a 14-year low, says James Laird, COO of Ratehub.ca.

“Fixed rates are expected to continue to rise in the near future. With rising mortgage rates, the stress test also continues to rise,” he says, adding, “For every percent that the stress test increases, a household is entitled to about 10% less mortgage.

“Currently, fixed rate mortgages are more difficult to obtain than variable rate mortgages. The homebuyer is stress tested using an additional rate two percent above the actual fixed rate they get from the lender. The higher their contract rate, the higher the stress test will be.

Real estate activity alone accounts for about 8% of Canada’s gross domestic product; but if additional economic events stimulated by the move are included, this rises to a fifth of GDP. This will contribute to slower economic growth,” says Ross.

“With secondary expenses like consumer durables and services like painting and moving, you get an incredibly high number of services that depend on that,” he says. “Also, from a government perspective, there are things like land transfer tax that generate a lot of revenue. The rise in the price of oil, he adds, should not be underestimated either. “Fifty to 60 percent increases at the pump change a household’s entire budget,” he says.

The economy is still at full capacity

Robert Hogue, senior economist at RBC, is firmly in the “recession-free” camp for now, though he says the outlook isn’t entirely certain even if the economy continues to operate at full capacity. “The Canadian economy will weaken, but our base case is that it will not fall into recession, although it could come close late next year. We have growth that slows down quite dramatically by the second half of 2023,” he told STOREYS.

Unemployment continues to be at historic lows, reaching 5.1% in May. Additionally, most industries rebounded as the economy reopened following the pandemic. But the troubling signs cannot be ignored.

“If you listen to the Bank of Canada, we are in a situation of excess demand. In this part of the cycle, it becomes much more difficult for the Canadian economy to grow because we lack the inputs and factors of production for further surplus, so the economy would slow down,” adds Hogue.

RBC maintains its stance that it expects the Bank of Canada to target an overnight funding rate range of 2-3% – which is considered “neutral” – but leaves the door open for it to that it exceeds this rate if the beast of inflation does not react to its efforts to rise. so far. At this point, a recession could indeed become a realistic expectation.

“If longer-term inflation expectations start to drift significantly higher, the Bank of Canada could well break out of the neutral range, so it would really start to rein in the economy and a scenario of recession would gain in probability,” he added. Hogue said.

“Our view, and I suspect it’s the consensus, is that the endpoint, or where the interest rate lands, will be in the neutral range between 2 and 3%, so by neutral it’s not not at the level that will really put the brakes on the economy. It will just take your foot off the accelerator.

After growing 3% year-over-year in the first quarter, the Canadian economy was expected to grow 6% in the second quarter before slowing in the second half of the year, Hogue added. .

“We have the cooling until about the middle of 2023, so we probably have a year left,” Hogue said. “Now that will calm down a major engine of growth that has helped the recovery since 2020, so that will end up in a calmer market with falling prices and to some extent that will contribute to the slowdown.”

Interest rates are still historically low

As Laird expects consumers to tighten their spending belts, the much sought-after “soft landing” remains within reach.

“Rates aren’t that high, they’ve just hit historic lows, so they feel high. Feeling is part of it, and feeling good will slow down consumer spending behavior,” he said. “But there are indicators that we could be soft landing, and one is the amount of savings that have been accumulated by households across the country. We have saved a lot of money over the past two years as a country, which should lessen the impact of rising rates.

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