On October 23, 2024, the Bank of Canada is set to announce its interest rate decision, with two-thirds of economists polled by Reuters expecting a 50 basis point cut to 3.75%. This follows a cumulative 75 basis point reduction since June, as inflation has eased to 1.6%, now within the Bank’s target range of 1%-3%, and the economy has slowed.

While declining interest rates tend to support the stock market, it’s the housing market and consumer spending that benefit most. Lower mortgage rates reduce borrowing costs, boosting housing demand, prices, and sales transactions. Combined with recent federal mortgage policy changes, these factors are likely to reignite housing activity in the near term.

Graph 1:  Canadian 5-year Mortgage rates and Residential Housing Activity

Last month, the federal government introduced key changes to its mortgage rules to ease affordability concerns. The extension of the amortization period for insured mortgages to 30 years (from 25 years) will reduce monthly payments by roughly 9%. Additionally, the easing of the mortgage stress test, allowing borrowers to switch lenders without re-qualifying, is expected to increase competition and improve mortgage terms. The cap for insured mortgages has also been raised to $1.5 million (from $1.0 million), reflecting higher home prices in major cities.

While these changes are expected to spur short-term housing activity, the IMF has cautioned that prolonged periods of low interest rates can lead to overheating in housing markets, potentially posing financial stability risks. Currently, housing investment and real estate services account for about one-fifth of Canada’s GDP, and these effects ripple through the TSX, particularly in sectors like financials and REITs.

Canadian Banks and REITs: Positioned for Gains

Canadian banks, which have about 40% of their loan portfolios in residential mortgages, are set to benefit from increased housing activity. Lower rates should boost lending and refinancing, supporting profitability. Bank stocks also benefit from stable net interest margins in residential lending, driving share prices higher.

Residential and retail REITs could also see upside. Increased housing demand drives up rental prices and property values, translating to higher returns for investors. Lower interest rates also reduce REITs’ debt servicing costs, improving profitability. Retail REITs may benefit from increased consumer spending on housing-related goods, while residential REITs remain supported by strong rental demand and tight supply.

Graph 2:  5-year Performance of Selected ETFs

Source: Koyfin

Mindful of Systemic Risks

Though a repeat of the 2008 U.S. housing crisis seems unlikely for Canada, the Bank of Canada remains mindful of the potential for a significant housing market downturn to create broader financial system risks. A sharp drop in home prices could lead to mortgage defaults, credit tightening, and negative spillovers into the broader economy, potentially impacting stock market performance. At this point, we believe the anticipated rate cut will ease financial strain on Canadians while providing continued support for the TSX60, particularly in sectors like banks and REITs.

As we reflect on the strong performance of equity markets over the past couple of years, we are now taking steps to adopt a more defensive stance in our portfolios. While we’ve been fortunate to benefit from meaningful positions in Gold and Bitcoin, along with an overweight exposure to the Nasdaq 100, we believe that shifting to asset classes with lower correlations to equities, while taking profits will help safeguard gains and manage potential risks while continuing to prioritize long term growth and stability for our clients.