Debt mountain casts shadow over the loonie

The Canadian dollar traded higher against the US dollar in recent days, as oil prices rose and domestic jobs surged. The currency was quoted at C$1.3081 earlier this week, near the C$1.2969 four-month high seen at the beginning of the month. Canada added 48,300 jobs in January, Statistics Canada said on Friday, as hiring in the service sector helped the labour market build on momentum from the latter part of 2016. The agreement in November by Opec to limit oil production continued to exert upward pressure on oil prices, and the producing group revised upwards its 2017 oil demand forecast for the third straight month. More expensive oil is a bullish sign for the Canadian dollar because oil is one of Canada’s major exports.

The strong numbers led to rising demand for short-term interest rate futures, which lifted the implied probability of a Canadian rate rise this year to more than 40% on February 10, compared with 22% the day before, and suggested more strength to come in the currency. But behind the strong news flow lurk potential challenges that speculators might be foolish to ignore.

“There is some momentum in Canadian economic fundamentals, and the employment figure was powerful,” says Steve Englander, global head of G10 FX strategy at Citigroup. “However, housing is a risk, because house prices are very high and consumers have borrowed a lot of money, which makes it harder to think that consumption can be a major driver of growth.”

Since 2002, Canada’s real estate house price index has risen 222%, according to data from the Organization for Economic Cooperation and Development, compared with a 78% rise in the US and 186% in the UK.

“House prices in Toronto, and especially Vancouver, which together make up one-third of the national housing market, are such that, in tandem with high household debt, they represent a significant financial vulnerability,” says Peter Jarrett, head of division, country studies, at the OECD economics department, in a blog last year.

He adds: “A sharp fall in house prices triggered by a shock that results in a large increase in unemployment could weaken households’ ability to service their debts, resulting in a rise in mortgage defaults that could endanger financial stability.”

Relative to income, house prices in Canada are fifth highest of a group of 21 countries, based on first-quarter 2016 data, according to the OECD. Relative to rents, they are second highest behind New Zealand. In September, the OECD cut Canada’s 2017 growth forecast to 2.1% from 2.2%, citing “financial distortions due to record-low interest rates”.

Canadian appetite for housing is reflected in wider measures of consumer debt, and with interest rates stuck at record lows, household borrowing reached the milestone in the second quarter of last year of exceeding the country’s GDP for the first time, hitting 100.5% of GDP, compared with 98.7% in the previous three-month period.

“The first warning sign came a couple of years ago when Canadian household debt surpassed US household debt as a proportion of income, and now that debt has reached record levels,” says Alfonso Esparza, Toronto-based senior currency strategist at FX trading platform OANDA. “I was shocked to see earlier this week that Tokyo real estate is cheaper than Toronto real estate, so it’s really amazing what has happened. It’s not right and the central bank knows it, but rates have been so low for so long and there is nothing in the economy to suggest that it is going to change.”

The Bank of Canada on January 18 left the target for its overnight lending rate at 0.5% and said that inflation was likely to remain below its 2% target in the months ahead. Still, it did highlight the high level of household debt and its potential impact on the economy.

“Given the high level of household indebtedness, households may also become more prudent, restraining consumption and housing expenditures,” the central bank said in the monetary policy statement accompanying its decision. In its biannual Financial System Review, published in December, it said increasing numbers of homebuyers were borrowing more money than they can pay back. Almost half of borrowers in Toronto owed more than 450% of their annual income, it said.

Concern over house prices was reflected in new federal rules in October aimed at shoring up risk in the mortgage market, including a requirement that buyers with mortgage insurance undergo stress tests, which came alongside a consultation into Canada’s unique federal cover for insured mortgages. The removal or watering down of that insurance would be likely to lead to higher interest rates for borrowers.

“Right now the Bank of Canada is in somewhat of a dilemma because if it lifts interest rates to rein in consumer spending they will inflict some pain on the economy and may see the dollar appreciate more than they want it to,” says Vasileios Gkionakis, head of global foreign exchange strategy at UniCredit Group in London. “On the other hand, if they do nothing and the credit boom seems to become entrenched then the balance of risks may shift and they would be forced to do something.”

Canadian dollar fair value against its US counterpart is around C$1.20, Gkionakis says, suggesting the central bank will likely stand pat, rather than encourage further appreciation, and hope the Canadian consumer does not see that as an invitation to keep on borrowing.