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Bank of Canada paints a healthy picture of the Canadian economy, even as interest rates continue to rise. But some say high household debt could pose a threat to the Canadian economy beyond 2020. Kim Parlee talks with Beata Caranci, Chief Economist, TD Bank Group.
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Bank of Canada governor Stephen Poloz has been painting a pretty rosy picture of Canada's economy, and last month he raised interest rates again. Those higher rates, as well as the persistent high household debt of Canadian consumers is raising alarm bells for some. Earlier, I spoke with Beata Caranci, she's Chief Economist at TD Bank Group, about what she is seeing and what the alarm bells are.
They've increased rates about five times in the last 16 months. And in their last communication in October, they made it very clear their intention is to continue to increase interest rates. And because we have elevated debt levels relative to history, even relative to when you compare to the US cycle pre recession, they're elevated. I think that's getting more on people's radar that, what if we have a policy mistake? And what does this mean for the average household who is already servicing their debt with a share of their income that's elevated, and then that's going to continue to rise as we go forward?
So that's why it's getting a bit more attention, based on where we are in the cycle.
And I suppose you add into it the psychology, the fact that we've just been used to having low interest rates for a really long time. So, you know, it may not feel like a lot or sound like it's going to be a lot, but then when we get the statements, we're like, oh, that was something.
Yes. And they're serious. They are raising interest rates. But it's important to remember, why are they doing it? They're not doing it in order to stress household finances. They're doing it because the job market is solid, income growth is strong, and we're at that point in the expansion where you could make the opposite policy mistake of leaving interest rates too low for too long and you fuel credit growth and exacerbate the risks that are already embedded in the economy.
So the Bank of Canada raising interest rates is actually them saying, we feel the economy strong enough to absorb it. They are watching key indicators. They have indicated in their financial stability review that household debt is their number one aspect that's on their watch list. So they will watch for delinquency rates. They will watch for pace of income growth, to see if that could compromise your ability to pay, job market, all those factors.
OK, you've got some charts we want to bring up and talk about. The first one we're looking at is falling interest rates made servicing debt cheaper. So again, you could take on more because you weren't paying as much every month. But what are we looking at here?
That's precisely it. Even though the debt-- like, home prices were rising at a fast rate, people were taking on more debt subsequently. You still saw the debt service ratio, so the share of income you're dedicating to servicing your mortgage and credit debt-- that ratio was actually falling because the interest rate profile was pulling it down. So you were able to take on more debt, but at the same time, your impact to your finances were not really felt because that interest rate was falling.
We're literally on the opposite end of that cycle now, where it's on the upswing. And so by extension, that's going to require the share of your income going to paying debt to rise, just by the simple math of it.
And you talk about this in the next chart we're looking at. This is your debt service ratio, and it's likely to eclipse previous peak. Now, tell me again why you care about this chart.
Well, if you think of it, what are people paying when you say your debt service ratio is going to eclipse previous peaks? Just over 70% of what you're paying in debt is your mortgage, and then the rest is your credit card and other debt.
So if your ability to pay your mortgage gets compromised, this has much more serious ramifications for the economy than, say, if it's credit card. Because it's such a large component and you need somewhere to live at the end of the day. You're either paying your mortgage or you're paying rent.
So the reality is that there will be a greater share going to servicing debt, and that has a direct impact to consumer spending profiles. It's one of the reasons why we hold a lower consumer spending profile in the Bank of Canada with the view that there just won't be as much discretionary spending on other areas of the economy because you will be directing more towards your finances.
The next chart we're looking at here has alternate scenarios of debt service costs. Tell me what this is.
OK, so this one is to push against a little bit of the fear that comes in that perhaps the Bank of Canada is being too aggressive on their interest rate cycle because debt levels are elevated. The top line is basically showing you the status quo. If you look at another three interest rate hikes coming in next year, which is our expectation, and you assume normal income growth, you will have the debt service ratio basically rise and exceed the previous peak level.
And that's not because the Bank of Canada is doing a ton of increases. It's just because we're coming off a low level and we have high debt levels. We actually don't think that's where we're going to end up. What we do see when you move through rising interest rate environments, you'll end up at the other two lines-- the middle line or the lower line-- because behaviors change.
So typically what happens is if you think only a quarter of mortgages, about, are on a variable rate. The rest are on a fixed term rate. So every five years they're coming up for renewal. When they come up for renewal, those who can, meaning they have 20% equity or more, will adjust behaviors to ask for extensions on their amortization, their unused portion. So they've had five years to pay, they might have had a 25-, 30-year mortgage. Now they have those extra five years.
So if you extend out your amortization period back, it keeps your debt service ratio fairly constant. But it does extend out the life of that mortgage, which means it will have longer term consequences--
You're paying it for longer.
Yeah. So what we do think is that you can mitigate some of that rise in the debt service ratio, but it does require some changes in terms of your contract as it is today.
Other behaviors that we know people do is those who are doing accelerated weekly payments, those who are doing lump sum payments, they may not choose to do those anymore. And so that gives them a little bit more financial freedom from that perspective to absorb the higher interest rates.
It does. But to your point, it gives them financial freedom in the short term but extends their obligation in the longer term.
Absolutely.
You got another chart here that takes a look at the, in the absence of a recession-- knock on wood, we do hope that is the case-- mortgage delinquencies to remain low.
Yeah, so they're rising but they're coming off a very low level. In fact, they're historically low. So they're abnormally low, one would say, relative to our own history. And the reason we say absence of a recession is you generally don't see large increases in delinquency rates without an income shock, and the income shock isn't because interest rates went up 75 basis points because I lost my job and I don't have the income to pay for the debt.
So delinquency rates don't lead a cycle. They tend to be an outcome of once you're in a recession and you're seeing those job impacts. We still expect to see a slight increase in that delinquency rate because there are groups of the households that are vulnerable. Like the Bank of Canada has identified that about 8% of households have, in terms of the debt to income ratio, at 350% or greater. So these are your more highly vulnerable, they're going to be more price sensitive in changes in interest rates.
And so that group is probably going to be more vulnerable to a rise in their delinquency rates. But that's not the majority of Canadians.
Let me ask you-- when you take a look at all this, then, and you are extrapolating out a year or two years, I mean, it sounds like you see things slowing. But, you know, no disasters are looming. Again, barring any major trade shock or anything else. But as it stands right now, this is just a bit of a slowdown.
Yeah, and this is the reason, and it's key in terms of why we have economic growth trending back towards 2% and lower in our forecasts, is because the consumer will be hard-pressed to be that engine of growth that it was in the past. And they do make up 60% of the economy in terms of economic output.
So, really, your thrust to growth comes from business investment, comes from trade flows, still comes from consumers, but to a much, a more reduced form of what we've seen in the past. And this is why, is because eventually you have to pay the piper and there's consequences and that results in slower growth on a longer term basis.
They've increased rates about five times in the last 16 months. And in their last communication in October, they made it very clear their intention is to continue to increase interest rates. And because we have elevated debt levels relative to history, even relative to when you compare to the US cycle pre recession, they're elevated. I think that's getting more on people's radar that, what if we have a policy mistake? And what does this mean for the average household who is already servicing their debt with a share of their income that's elevated, and then that's going to continue to rise as we go forward?
So that's why it's getting a bit more attention, based on where we are in the cycle.
And I suppose you add into it the psychology, the fact that we've just been used to having low interest rates for a really long time. So, you know, it may not feel like a lot or sound like it's going to be a lot, but then when we get the statements, we're like, oh, that was something.
Yes. And they're serious. They are raising interest rates. But it's important to remember, why are they doing it? They're not doing it in order to stress household finances. They're doing it because the job market is solid, income growth is strong, and we're at that point in the expansion where you could make the opposite policy mistake of leaving interest rates too low for too long and you fuel credit growth and exacerbate the risks that are already embedded in the economy.
So the Bank of Canada raising interest rates is actually them saying, we feel the economy strong enough to absorb it. They are watching key indicators. They have indicated in their financial stability review that household debt is their number one aspect that's on their watch list. So they will watch for delinquency rates. They will watch for pace of income growth, to see if that could compromise your ability to pay, job market, all those factors.
OK, you've got some charts we want to bring up and talk about. The first one we're looking at is falling interest rates made servicing debt cheaper. So again, you could take on more because you weren't paying as much every month. But what are we looking at here?
That's precisely it. Even though the debt-- like, home prices were rising at a fast rate, people were taking on more debt subsequently. You still saw the debt service ratio, so the share of income you're dedicating to servicing your mortgage and credit debt-- that ratio was actually falling because the interest rate profile was pulling it down. So you were able to take on more debt, but at the same time, your impact to your finances were not really felt because that interest rate was falling.
We're literally on the opposite end of that cycle now, where it's on the upswing. And so by extension, that's going to require the share of your income going to paying debt to rise, just by the simple math of it.
And you talk about this in the next chart we're looking at. This is your debt service ratio, and it's likely to eclipse previous peak. Now, tell me again why you care about this chart.
Well, if you think of it, what are people paying when you say your debt service ratio is going to eclipse previous peaks? Just over 70% of what you're paying in debt is your mortgage, and then the rest is your credit card and other debt.
So if your ability to pay your mortgage gets compromised, this has much more serious ramifications for the economy than, say, if it's credit card. Because it's such a large component and you need somewhere to live at the end of the day. You're either paying your mortgage or you're paying rent.
So the reality is that there will be a greater share going to servicing debt, and that has a direct impact to consumer spending profiles. It's one of the reasons why we hold a lower consumer spending profile in the Bank of Canada with the view that there just won't be as much discretionary spending on other areas of the economy because you will be directing more towards your finances.
The next chart we're looking at here has alternate scenarios of debt service costs. Tell me what this is.
OK, so this one is to push against a little bit of the fear that comes in that perhaps the Bank of Canada is being too aggressive on their interest rate cycle because debt levels are elevated. The top line is basically showing you the status quo. If you look at another three interest rate hikes coming in next year, which is our expectation, and you assume normal income growth, you will have the debt service ratio basically rise and exceed the previous peak level.
And that's not because the Bank of Canada is doing a ton of increases. It's just because we're coming off a low level and we have high debt levels. We actually don't think that's where we're going to end up. What we do see when you move through rising interest rate environments, you'll end up at the other two lines-- the middle line or the lower line-- because behaviors change.
So typically what happens is if you think only a quarter of mortgages, about, are on a variable rate. The rest are on a fixed term rate. So every five years they're coming up for renewal. When they come up for renewal, those who can, meaning they have 20% equity or more, will adjust behaviors to ask for extensions on their amortization, their unused portion. So they've had five years to pay, they might have had a 25-, 30-year mortgage. Now they have those extra five years.
So if you extend out your amortization period back, it keeps your debt service ratio fairly constant. But it does extend out the life of that mortgage, which means it will have longer term consequences--
You're paying it for longer.
Yeah. So what we do think is that you can mitigate some of that rise in the debt service ratio, but it does require some changes in terms of your contract as it is today.
Other behaviors that we know people do is those who are doing accelerated weekly payments, those who are doing lump sum payments, they may not choose to do those anymore. And so that gives them a little bit more financial freedom from that perspective to absorb the higher interest rates.
It does. But to your point, it gives them financial freedom in the short term but extends their obligation in the longer term.
Absolutely.
You got another chart here that takes a look at the, in the absence of a recession-- knock on wood, we do hope that is the case-- mortgage delinquencies to remain low.
Yeah, so they're rising but they're coming off a very low level. In fact, they're historically low. So they're abnormally low, one would say, relative to our own history. And the reason we say absence of a recession is you generally don't see large increases in delinquency rates without an income shock, and the income shock isn't because interest rates went up 75 basis points because I lost my job and I don't have the income to pay for the debt.
So delinquency rates don't lead a cycle. They tend to be an outcome of once you're in a recession and you're seeing those job impacts. We still expect to see a slight increase in that delinquency rate because there are groups of the households that are vulnerable. Like the Bank of Canada has identified that about 8% of households have, in terms of the debt to income ratio, at 350% or greater. So these are your more highly vulnerable, they're going to be more price sensitive in changes in interest rates.
And so that group is probably going to be more vulnerable to a rise in their delinquency rates. But that's not the majority of Canadians.
Let me ask you-- when you take a look at all this, then, and you are extrapolating out a year or two years, I mean, it sounds like you see things slowing. But, you know, no disasters are looming. Again, barring any major trade shock or anything else. But as it stands right now, this is just a bit of a slowdown.
Yeah, and this is the reason, and it's key in terms of why we have economic growth trending back towards 2% and lower in our forecasts, is because the consumer will be hard-pressed to be that engine of growth that it was in the past. And they do make up 60% of the economy in terms of economic output.
So, really, your thrust to growth comes from business investment, comes from trade flows, still comes from consumers, but to a much, a more reduced form of what we've seen in the past. And this is why, is because eventually you have to pay the piper and there's consequences and that results in slower growth on a longer term basis.
