Canadian Economy Stagnates in Q2 2023: Potential Impact on Interest Rates

The State of the Canadian Economy in Q2 2023

In the latest data released by Statistics Canada (StatCan) this morning, the Canadian economy experienced stagnation during the second quarter of the year.

Key Economic Figures for Q2 2023

StatCan reports that the Canadian economy contracted by an annualized rate of 0.2% in Q2 2023, a figure significantly lower than the Bank of Canada's earlier prediction of 1.5% growth. Additionally, StatCan revised the growth rate for the first quarter, reducing it to an annualized rate of 2.6% from the previously reported 3.1%.

Factors Contributing to Second-Quarter Weakness

A significant contributing factor to this weakness was a 0.2% decline in output in June.

Impact of High Interest Rates and Housing Prices

As expected, given the prevailing high interest rates and housing prices, investment in the housing sector continued to decline in the second quarter, primarily due to reduced new construction activity.

Consumer Spending and Its Trends

Consumer spending showed a modest increase of 0.2%, but this was the smallest uptick since the pandemic lockdowns in Q2 2021. Furthermore, the growth in real household spending slowed to 0.1% in Q2, compared to 1.2% in the first quarter, reflecting the significant impact of inflation and higher borrowing costs.

Other Contributing Factors: Inventory and Exports

The data indicates that the second-quarter weakness can also be attributed to reduced inventory accumulation and a slower pace of growth in exports. Canada's exports of goods and services only increased by 0.1% in Q2, compared to a more substantial 2.5% increase in the first quarter.

Stability in July's GDP and the Rise in Inflation

Preliminary estimates suggest that the GDP for July remained relatively stable. In August, the country's inflation rate ticked higher as mortgage costs continued to rise for the fifth consecutive month, marking the most significant increase on record.

Anticipation for the Bank of Canada's Decision

Many Canadians are eagerly awaiting the Bank of Canada's (BoC) upcoming interest rate decision next week, especially after the BoC raised its key interest rate target by a quarter of a percentage point to 5% in July.

Impact of Higher Interest Rates and RBC's Insights

These latest statistics reveal that the effects of higher interest rates are beginning to have an impact, resulting in a cooling economy with reduced consumer spending – precisely the intended outcome of monetary policy. In response to the latest economic data released this morning, RBC Economics, in their Daily Economic Update, has indicated that these numbers are likely to strengthen the prevailing expectations that the Bank of Canada (BoC) will abstain from implementing another interest rate hike.

Analyzing RBC Economics' Perspective

The commentary in the update notes that the minor decline in the second quarter is not entirely unexpected, as previous early estimates of GDP have exhibited a tendency to be revised. Furthermore, there have been indications suggesting that the obstacles to economic growth resulting from elevated interest rates have been quietly accumulating beneath the surface.

The Path Forward for Interest Rates

RBC recognizes that the central bank is unlikely to overly emphasize a single data point and acknowledges that inflation remains persistently above the targeted levels. Nonetheless, a cooling economy may provide some relief for borrowers. The update contends that there is accumulating evidence that the delayed consequences of earlier interest rate hikes are starting to exert a more pronounced impact in moderating both GDP growth and labor markets. Consequently, this should lead to a gradual slowdown in inflationary pressures. The update further posits that policymakers will want to maintain the option of resuming rate hikes if necessary. However, if the unemployment rate continues to rise, as anticipated, a resumption of rate hikes may not be required.


Does the Bank of Canada's most recent rate hike mark the ultimate demise?

On Wednesday, the Bank of Canada raised its overnight rate by 25 basis points, bringing it to 5.0 percent. This decision is part of a significant tightening of monetary policy, returning interest rates to levels not seen since the 2007-08 financial crisis. For some, this latest rate hike feels like the decisive blow that solidifies a troubling situation, while others hope it truly marks the end of rate increases. Tiff Macklem, the governor of the Bank of Canada, expresses uncertainty and asserts that further rate hikes are not off the table if deemed necessary.

The recent unexpected rate hike appears to have had an immediate impact on the sentiment of the real estate market. It could be seen as another minor warning sign, similar to the initial 25 basis point hike in February 2022, as it has achieved a comparable outcome. There are reports of distress among homeowners circulating within the real estate community, with many professionals publicly expressing empathy towards those facing difficulties.

As a result of the rate hike, commercial bank prime rates have risen to 7.20 percent. Consequently, variable rate mortgages are now hovering around the 6.0 percent range, while HELOCs (Home Equity Lines of Credit) are surpassing 7.50 percent for most borrowers. This represents a significant increase from the rates of approximately 3.0 percent that instilled great confidence in the market during the peak of the pandemic era.

Following the announcement of the rate hike, the Canada 5-Year Government Bond yield experienced a consistent decline throughout the day on July 12. It started at 3.950 percent at the opening and closed at 3.812 percent. The yields have remained relatively stable within this range, which holds crucial importance as it serves as the primary pricing gauge for fixed-rate mortgages.

In Canada, fixed-rate mortgages are closely linked to government bond yields, specifically the yields of Government of Canada bonds with similar maturity periods. As bond yields rise, lenders are compelled to raise mortgage rates to make them more attractive investments compared to those bonds. If not, banks would prefer investing their funds in bonds, which are regarded as one of the safest investment options. Typically, banks add a risk premium to mortgage products, resulting in pricing at "GOC+2" or the bond yield plus 2.0 percent. Based on the current yields, this would translate to mortgage rates in the range of high 5.0 percent to low 6.0 percent.

Conversely, when bond yields decline, fixed mortgage rates tend to follow suit, making them more affordable for borrowers. Therefore, fluctuations in Canadian bond yields play a significant role in influencing the direction of fixed mortgage rates in the country.

This is the primary challenge faced by the Bank of Canada. Currently, a majority of homebuyers opt for fixed-rate mortgages due to their more favorable pricing compared to variable-rate mortgages. Consequently, when the central bank raises the interest rate, it does not significantly affect the demand side of the equation. Instead, it exerts pressure on the supply side, leading to financial strain and creating an incentive for property owners to sell. From the sounds of it, this is precisely the outcome they have achieved, as an increasing number of sellers are conceding to the Bank of Canada's influence. As a result, new property listings are generally surpassing sales, a trend that hasn't been observed for some time.

The Bank of Canada's focus on the housing market became evident through its Quarterly Monetary Policy report. Additionally, during the subsequent press release, Governor Macklem indicated a shift in reliance from unemployment as a key performance indicator (KPI) to placing increasing importance on the housing market and immigration in establishing potential outcomes for the Canadian economy.

In the release, Macklem acknowledged the significant impact of the interest rate hikes on the housing market, leading to a notable slowdown. However, he also noted that the slowdown was not as substantial as initially anticipated, and housing activity has since rebounded.

Macklem referred to the previous year's significant decline in house prices, which began following the initial rate hike in February. This decline resulted in a nearly 20 percent year-over-year drop in house prices, surpassing the previous record "crash" in house prices experienced by Canada in 1989.

Now we come to the significant questions: Is the ordeal reaching its conclusion? When will things start improving?

Initially, Macklem hinted that 5.0 percent might be the limit or the point at which he would cease increasing the overnight rate. We must remember that the Bank of Canada (BoC) has a mandated target rate of 2% to achieve. Finally, the overnight rate has significantly exceeded the inflation rate. This indicates that, when adjusted for inflation, the real interest rate has become positive.

The real interest rate is calculated as the nominal interest rate minus the inflation rate.

Traditionally, the nominal interest rate needs to align with the inflation rate before a reversion begins. On average, interest rates tend to remain at their peak for around nine months before rate cuts are implemented.